City Research Online

Abstract

How are financial markets pricing the monetary policy outlook? We use surveys to decompose excess returns on money market instruments into expectation errors and term premia. Excess returns are primarily driven by expectation errors, whereas term premia are negligible. Investors face challenges when learning about the Federal Reserve's response to large, but infrequent, negative shocks in real-time. Rather than reflecting risk compensation, excess returns stem from investors underestimating how much the central bank eases policy in response to such rare shocks. We show, for the US and internationally, that expectation errors imply excess return predictability from past stock returns.

Publication Type:	Article
Additional Information:	© 2022. This manuscript version is made available under the CC-BY-NC-ND 4.0 license https://creativecommons.org/licenses/by-nc-nd/4.0/
Publisher Keywords:	Expectation formation, Monetary policy, Federal funds futures, Overnight index swaps, Uncertainty
Subjects:	H Social Sciences > HJ Public Finance
Departments:	Bayes Business School > Finance
SWORD Depositor:	Symplectic Administrator

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