Impact of uncertainty on high frequency response of the U.S. stock markets to the Fed's policy surprises

• This paper highlights the role of uncertainty in monetary policy effectiveness.
• The response of S&P to monetary policy surprises is estimated using TVP model.
• The S&P response is analyzed using VIX index and alternative measures of uncertainty.
• We find negative relation between uncertainty and S&P response to FOMC surprises.

This paper examines the impact of uncertainty on estimated response of stock returns to U.S. monetary policy surprise. This is motivated by the Lucas island model which suggests an inverse relationship between the effectiveness of a policy and the level of uncertainty in the economy. Using high frequency daily data from the Federal funds futures market, we first estimate the response of S&P 500 stock returns to monetary policy surprises within the time varying parameter (TVP) model. We then analyze the relationship of these time varying estimates with the benchmark VIX index and alternative measures of uncertainty. Evidence suggests a significant negative relationship between the level of uncertainty and the time varying response of S&P 500 stock returns to unanticipated changes in the interest rate. Thus, at higher levels of uncertainty the impact of monetary policy shocks on stock markets is lower. The results are robust to different measures of uncertainty.