The impact of monetary policy on equity markets and financial institutions

I examine the impact of monetary policy actions on the returns of manufacturing firms and financial institutions. I observe that the financial institutions are more affected by monetary policy actions compared to manufacturing firms. I find that the response of the returns of financial institutions to surprise monetary policy actions is large and statistically significant. Returns are statistically significantly affected by positive policy surprises (larger than expected value of the federal funds target rate) while they are not significantly affected by negative positive surprises.; I also observe that the effects of monetary policy on the financial institutions are asymmetric across different monetary policy environments and business conditions and the results are robust to different identification schemes of the business conditions. I find evidence that the effect of monetary policy on the returns of financial institutions in good business conditions is statistically significant compared to bad business conditions. Furthermore, I find that the asymmetric effect of monetary policy across different monetary policy environments and business conditions are due to the asymmetric effect of monetary policy on the discount rates and expected cash flow proxies. The results imply that the monetary policy plays a strong signaling role for the stock market and that any asset-pricing model for financial institutions should take into account the effect of monetary policy by incorporating an interest rate-based indicator of monetary policy in the model.; I also investigate the stock price reaction to anticipated and unanticipated monetary policy actions. I find that the effect of unanticipated, unsystematic policy shock on stock returns is larger in magnitude but short-lived while the effect of anticipated, systematic policy is smaller in magnitude but persistent. Moreover, I observe a resolution of the ‘price puzzle’, which shows that the puzzle is probably the result of the failure to identify the monetary policy shock correctly in the vector autoregression (VAR) framework. Once I ‘correctly’ identify the monetary policy shock, either using Taylor rule or a market based proxy for expected monetary policy (federal funds futures rate), the price puzzle disappears.