Question

1. Stock Prices, Expectations, and Policy Changes

Explain, using the expectations model (and their role in determining asset prices) how the stock market is likely to react to each of the following scenarios:

a) The Fed, as expected, raises the policy rate by 0.25 percentage points (25 basis points).

b) The Fed unexpectedly raises the policy rate by 0.50 percentage points (50 basis points).

c) At a meeting in which a rate hike was widely anticipated, the Fed surprises observers by leaving the policy rate unchanged.

d) The latest BLS jobs report shows no change in the unemployment rate, a number of jobs added that is in line with expectations, and a surprisingly strong rate of wage growth.

e) The government, as expected, enacts a $1 trillion tax cut.

f) The government unexpectedly announces the elimination of several government programs totaling $400 billion in annual government spending.

Answer 1

1. The expected hike in policy rate is likely to have minimal impact on the stock price as efficient market would have already factored it in.
2. The unexpected hike in policy rate is likely to have mild negative impact on the stock prices as it lowers the risk premium for the stocks by offering higher returns on other secure instruments.
3. The unchanging of the policy rate is likely to have slight positive impact as the market expected the rate to be hiked and would have factored in the negative news.
4. Better than expected job data has positive impact on the stocks as such increase signs to a healthy economy where high demand is expected to boost industrial sector as well as the stock market.
5. Tax cut is expected to have positive impact on the industrial sector as well as on the stock market.
6. Lower government spending leads to lower deficit, providing a boost to the economy and expected to have positive impact on the stock market.