Risk Appetite and Monetary Transmission

Abstract: We construct a new high-frequency measure of changes in risk appetite around Federal Open Market Committee (FOMC) meetings. Fed policy actions and communication have substantial effects on risk appetite, consistent with the literature on the risk-taking channel of monetary policy. Most of the variation in asset prices and risk appetite is unexplained by conventional interest-rate surprises, which raises the possibility of an important role of risk appetite in monetary transmission. Using a proxy SVAR with two separately-identified shocks, we find that risk appetite shocks have large, significant, and theory-consistent effects on prices and real activity. By contrast, the effects of risk-free rate shocks become insignificant or switch signs once the risk appetite shock is included. This evidence suggests that monetary transmission operates primarily through risk asset prices and risk appetite. We argue that standard estimation of monetary transmission based solely on interest-rate surprises misses most of these effects for two reasons: First, the impact of interest-rate policy on asset prices is time-varying and state-dependent. Second, central bank communication can affect risk appetite and asset prices in ways that go beyond changes in the expected policy path.