DP14017 Stock Market's Assessment of Monetary Policy Transmission: The Cash Flow Effect

Author(s): Refet S. Gurkaynak, Gokce Karasoy Can, Sang Seok Lee
Publication Date: September 2019
Keyword(s): Cash flow effect of monetary policy, Financial Frictions, Investor sophistication, stock pricing
JEL(s): E43, E44, E52, E58, G14
Programme Areas: Financial Economics, Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=14017

We show that firm liability structure and associated cash flow matter for firm behavior, and that financial market participants price stocks accordingly. Looking at firm level stock price changes around monetary policy announcements, we find that firms that have more cash flow exposure see their stock prices affected more. The stock price reaction depends on the maturity and type of debt issued by the firm, and the forward guidance provided by the Fed. This effect has remained intact during the ZLB period. Importantly, we show that the effect is not a rule of thumb behavior outcome and that the marginal stock market participant actually studies and reacts to the liability structure of firm balance sheets. The cash flow exposure at the time of monetary policy actions predicts future net worth, investment, and assets, verifying the stock pricing decision and also providing evidence of cash flow effects on firms' real behavior. The results hold for S&P500 firms that are usually thought of not being subject to tight financial constraints.