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The implied equity risk premium and fed’s monetary policy

Daniele Di Giulio
April 2009 - n°4

The paper evaluates how the Fed reacted to inflation, output gap, and the equity risk premium perceived in the US stock market during the period 1985-2008. Our econometric estimates of an “augmented forward looking Taylor rule” show a negative and statistically significant relation between the implied equity risk premium and the Fed’s policy rate. Furthermore, the monetary policy reaction appears stronger and more significant as investors’ risk aversion rises. This empirical evidence suggests that the US monetary policy during the analyzed period aimed at minimizing the risk that investors, through irrational behaviour, could cause relevant stock prices contractions in periods of increasing risk aversion and decreasing market confidence.