Stock returns and monetary policy stance

This paper investigates the structural relationships between monetary policy and stock returns. We build an asset pricing model incorporating a standard Taylor rule into a consumptionCAPM framework. Our model quantitatively explains the negative risk premium of expansionary monetary policy. As monetary policy plays a role of insurance, (expansionary) monetary policy beta is negatively related to covariances of returns with output gap and inflation theoretically and empirically. In addition, while systematic responses mainly account for the negative risk premium, pure monetary policy shocks have little influence under plausible calibrations. We also provide theoretical predictions on how the slope of the Phillips curve and the response parameters of monetary policy affect the cross-section of returns.