Macro-International Seminar with Carolin Pflueger (University of Chicago)

Abstract: The same habit preferences that explain the equity volatility puzzle in quarterly data also naturally explain large high-frequency stock responses to monetary policy news. To show this, we newly integrate a work-horse New Keynesian model with habit formation preferences. The model generates endogenously time-varying risk premia from level shocks to interest rates because a surprise increase in the short-term interest rate lowers output and consumption relative to habit, raising risk aversion and amplifying the fall in stocks. The model explains the positive comovement between long-term breakeven and stocks on FOMC dates with news about long-term inflation.

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