MONETARY TRANSMISSION MECHANISMS: Deconstructing Surprise Shocks in the U.S. Bond Market

Abstract

This thesis is aimed at finding empirical support for the notion that individuals have the ability, and propensity, to influence monetary transmission mechanisms––and in turn, the overall effectiveness of monetary policy––through means of market expectations and risk attitudes. Within the context of the U.S. bond market, I investigate the transmission of monetary policy surprise shocks in particular to various points along the term structure for a range of fixed income instruments. Specifically, I apply behavioral insights to employ an event-study analysis centered around FOMC announcements that analyzes and measures the surprise shock and information effects associated with changes in the federal funds rate. I find there exists both short- and long-term rate reactions to monetary policy, with the shorter end of the term structure exhibiting a greater response. The evidence also implies the reactions of bond prices to policy shifts can be expressed, at least in part, by changes in risk premia. This idea that monetary policy and bond prices are related through attitudes toward risk is based in the notion that a greater deviation from market expectations (a greater surprise shock) results in more risk premia requested for uncertainty (lower risk appetite of investors). On a theoretical front, this thesis contributes to a strain of research that seeks to update interest rate theory prescribed by standard macroeconomics and in particular, the Expectations Hypothesis and monetary neutrality. In practical application, the empirical results point toward a confluence of monetary transmission mechanisms reliant on market expectations and risk attitudes, underscoring the crucial implementation of alternative policy methods beyond setting the federal funds rate.