How Monetary Uncertainty Affects Market Volatility

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Monetary policy is the process by which a government, central bank, or monetary authority manages the money supply to achieve specific objectives. In most countries, these objectives are stabilization of prices and maintenance of low inflation. Monetary policy is also used to manage economic growth, employment, and exchange rates.

Monetary policy is typically implemented by adjusting the interest rate at which banks lend money to each other overnight. This influences other interest rates in the economy and ultimately the return on investment and spending decisions of households and businesses.

There are two main types of monetary policy: expansionary and contractionary. Expansionary policy is when a monetary authority increases the money supply in order to stimulate economic growth. Contractionary policy is when a monetary authority decreases the money supply in order to reduce inflation.

Reference [1] examined the impact of monetary policy uncertainty on stock market volatility. It pointed out,

Contrary to the conventional wisdom, we find that monetary policy uncertainty negatively predicts stock market volatility both in and out of sample. The predictability is robust even after controlling for a comprehensive set of economic variables related to business and financial cycles. The predictability is stronger for large firms, profitable firms, and past winner firms. …

Economic uncertainty, other policy uncertainty, economic conditions cannot fully explain the negative relationship. We explore the economic sources of this negative relationship. Higher monetary policy uncertainty tends to decrease both the future cash flow volatility and the future discount rate volatility. When decomposing volatility into good and bad volatility, the predictive ability of monetary policy uncertainty arises primarily from information on future downside risk.

In short, the authors concluded, surprisingly, that higher monetary policy uncertainty will lead to lower market volatility.

The paper suggested that monetary policy uncertainty has an impact on asset prices.  Therefore we believe that it would be beneficial to incorporate monetary policy uncertainty into trading and risk-management frameworks.

References

[1] Ma, Chaoqun and Hsiao, Shisong and Zhang, Ting and Deng, Liurui, Monetary policy uncertainty and stock market volatility, 2022,https://ssrn.com/abstract=4013502

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