Monetary Policy Uncertainty: Sources and Consequences

Why do stocks and bonds sometimes hedge each other and sometimes move together? We show that an unexplored explanation lies in the source of uncertainty about the future path of monetary policy. Using daily revisions in policy rate expectations, we decompose a novel market-based measure of policy path uncertainty into macroeconomic uncertainty and uncertainty about the Federal Reserve's reaction function. These two components generate sharply different macroeconomic dynamics. Macroeconomic uncertainty lowers output and inflation, prompting monetary policy easing, while reaction function uncertainty produces stagflationary pressures and monetary policy tightening. These contrasting dynamics carry through to financial markets. Both uncertainty sources reduce equity valuations, but macroeconomic uncertainty lowers Treasury yields whereas policy response uncertainty raises yields through higher real term premia. Consequently, stock-bond correlations turn negative when macroeconomic uncertainty dominates and positive when reaction function uncertainty prevails. Our decomposition thus provides a structural explanation for why the stock-bond correlation switches sign over time.