Elucidating the Mechanism of Large Firms' Stock Price Overreactions to Monetary Policy
This paper elucidates through both empirical and theoretical analyses that the phenomenon of large firms' stock prices reacting more strongly to monetary policy surprises than those of small firms is not due to inherent differences in monetary policy sensitivity as previously thought, but rather due to overestimation bias caused by investors' recognition errors of policy rules. The authors are Masayuki Okada from the Institute for Monetary and Economic Studies (IMES) of the Bank of Japan and Kazuhiro Teramoto from Hitotsubashi University.
Discovery of Endogeneity Problems in High-Frequency Identification Methods
Previous studies used changes in interest rate futures 30 minutes around FOMC announcements (10 minutes before to 20 minutes after) as "monetary policy surprises" as proxy variables for policy shocks. However, this research focuses on the fact that these surprises are predictable from prior information, identifying endogeneity problems where market participants' incomplete understanding of policy rules generates estimation bias. Empirical analysis revealed that this endogeneity affects large firms disproportionately, while its impact on small firms is minimal.
Construction of Granular Origins of Aggregate Fluctuations Theoretical Model
For theoretical explanation, the research team developed an asset pricing model incorporating Gabaix's (2011) granular origins of aggregate fluctuations theory. This model assumes an economy composed of a continuum of small firms and a finite number of large firms, where idiosyncratic shocks to large firms contribute to aggregate fluctuations through granular channels, while small firm shocks remain uncorrelated with the aggregate economy. Consequently, large firms' performance and profits exhibit significantly higher correlation with aggregate economic conditions than small firms.
Asymmetry of Stochastic Discount Factor and Monetary Policy
In the model, households have utility from money holdings, causing the stochastic discount factor (SDF) to be endogenously linked to nominal interest rates. While the central bank follows policy rules responding to aggregate indicators like the GDP gap, the magnitude of large firms' impact on the aggregate economy causes interest rate changes to unintentionally correlate more strongly with large firm fundamentals. Importantly, it is not that large firms' fundamental conditions (production, profits, dividends) are inherently sensitive to monetary policy shocks, but rather that monetary policy becomes more responsive to large firms as a result of their role in forming macroeconomic aggregates.
Explanation of Stock Price Reactions Through Belief Revision Channels
In information friction environments where investors do not fully understand policy rule parameters, monetary policy surprises reflect both actual policy shocks and gaps in policy rule recognition. Investors update their policy rule predictions through Bayesian learning, and since the SDF depends on nominal interest rates, belief revisions directly affect asset prices. Under the presence of granular origins of aggregate fluctuations, this belief-driven SDF change generates heterogeneous stock price reactions, working more prominently on large firms' risk premiums (covariance between SDF and firm profits).
Empirical Results and Policy Implications
After properly addressing endogeneity, estimated reaction differences between firm sizes were substantially smaller than previously reported, revealing that large firms' strong stock price reactions are belief-driven movements rather than fundamental differences in monetary policy sensitivity. This research issues important warnings about the validity of high-frequency identification methods and demonstrates the necessity of reconsidering identification strategies in corporate heterogeneity research.