Unexpected interest rate cuts by the Federal Reserve appear to lower investor expectations for dividend growth by more than 50 basis points at short maturities, according to new research published August 12 by economists at the Federal Reserve Bank of New York. The study by Henry Dyer and Tomas Jankauskas examines how monetary policy surprises from 1988 to 2020 influenced the term structure of equity risk premia and growth expectations across different investment horizons. The findings suggest that rate shocks primarily affect market expectations through growth forecasts rather than risk appetite.
The research shows that dovish monetary policy surprises—unexpected rate cuts—are linked to a decline in expected dividend growth rates of over 50 basis points for the shortest maturities and roughly 20 basis points for the longest maturities. Both positive and negative monetary policy surprises are associated with a parallel upward shift in the average risk premium of approximately 25 basis points, uniform across different maturities. In contrast, hawkish surprises—unexpected rate hikes—do not produce the same pattern of reduced growth expectations, suggesting that tightening often reflects strong demand conditions rather than deteriorating economic prospects. Over the full sample period from 1988 to 2020, the term structure of risk premia slopes upward, starting slightly negative for the shortest maturities and converging toward 3.6 percent at the fifteen-year horizon, while expected dividend growth rates remain relatively stable at around three percent.
The authors note that their findings offer some support for the information channel of monetary policy surprises. According to the report, large rate cuts typically occur around the onset of economic distress and therefore signal deteriorating growth prospects, which explains the sharp drop in dividend growth expectations following dovish surprises. The researchers acknowledge that the effects of both negative and positive surprises on risk premia are not very large in economic magnitude and are statistically insignificant, but they suggest this may be explained by the fact that at most FOMC meetings, these surprises are very small. The study builds on work by Giglio, Kelly, and Kozak (2024), applying their model to disentangle risk premia from dividend growth rates across a broad range of maturities.
The asymmetric response to rate surprises points to an important dynamic in how markets interpret Fed actions. When the central bank unexpectedly cuts rates, investors appear to read it as a warning signal about future corporate earnings and economic activity, causing them to mark down their forecasts for dividend growth. But when the Fed unexpectedly raises rates, markets don't necessarily interpret it as a negative growth signal—likely because hikes often respond to inflationary pressures or overheating demand rather than underlying weakness. This suggests that monetary policy surprises carry information about the economy that extends beyond the direct mechanical effect on discount rates. The upward-sloping term structure of risk premia indicates that investors demand substantially higher compensation for bearing long-term equity risk, consistent with asset pricing models that emphasize aversion to long-duration cash flows. The research highlights that understanding the equity term structure and its interaction with monetary policy remains an active area of study with important implications for how investors price stocks across different time horizons.