The Fed and the stock market: A tale of sentiment states

Abstract

We analyze the period before the zero lower bound and show that the state of investor sentiment strongly affects the transmission of monetary policy to the stock market. The impact of Federal funds rate (FFR) surprises is mostly potent when sentiment-driven overvaluation is followed by a correction, whereby the stock market increases by 0.8% in response to an unexpected FFR cut of 10 basis points. Monetary easing surprises boost the stock market by alleviating investors’ fear and consequently, increasing their willingness to bear risk.

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