Why the Fed’s Impact Goes Beyond Interest Rates

The Federal Reserve may have more power to affect financial markets and the broader economy than commonly thought.

A new working paper by Paymon Khorrami and Anna Cieslak of Duke University’s Fuqua School of Business shows that the US central bank’s toolkit has widened beyond short-term interest-rate decisions, deepening the Fed’s ability to affect the perception of risk and long-term investments.

In Monetary Shocks and Long-Run Neutrality in Asset Pricing, Khorrami and Cieslak found that in the short time windows around the Fed’s monetary announcements, the prices of long-term assets like stocks and 30-yr bonds sometimes move out of sync — a condition that violates long-held assumptions about the economic neutrality of the central bank’s monetary decisions in the long term.

The researchers found that especially after the 2008 financial crisis, the Fed’s communications around its use of tools like forward guidance and asset purchases impacted markets in ways that have little to do with short-term rate setting.

“Although we spend a disproportionate amount of time thinking about the interest rate, a disproportionate amount of the impact comes from more nuanced things like the Fed’s communication,” Khorrami said.

Fed’s tools beyond interest-rate setting

The most widely understood form of communication from the Fed is through the bank’s Federal Open Market Committee (FOMC), which announces decisions about the short-term interest rate, also called the “federal funds rate.” These announcements are regularly scheduled, usually eight times a year. 

However, over the past fifteen years, the Fed has increasingly deployed other tools to affect markets. These include forward guidance, asset purchases and, in general, strategic communication.

One way the Fed uses forward guidance is through statements about plans for future rates.

“In 2010-2012, for example, they were reiterating that they intended to keep the short rate at zero for an extended period, and then they would give times and contingencies for this to change,” Khorrami said. 

Another tool in the Fed’s arsenal is the direct purchase of assets, commonly known as “quantitative easing” (QE). Typically, the Fed commits to buying long-term bonds to stabilize their markets, Khorrami said.

“The general thinking is that by taking these bonds out of private hands, the typical investor becomes less risk-averse and is willing to hold these bonds at a lower yield,” he said.

In general, communication itself is another policy tool that captures the Fed’s thinking about the economy and its future strategies. 

“It can hint at future plans and contingencies for asset purchases, or for future short rates, and the investors have to decide how to interpret that.” 

Fed’s influence on stocks and bonds

But how do all these moves affect markets? 

In the textbook case, when the Fed increases rates to reduce inflation, there might be temporary frictions. The idea is that, after higher rates have dampened demand, prices will adjust and bring the economy back to its previous equilibrium.

That interest rate decision is not intended to affect economic expectations about long-term economic growth or the general perception of long-term risk in the economy. Specifically, if the Fed’s announcements were fundamentally neutral for the long-term economic trajectory, we should see prices of long-term assets like stocks and long-term bonds react the same way, Khorrami said.

“They are both long-term assets, and the only thing that the Fed’s short-term rate affects is the discount rate of stocks’ future dividends and of bonds’ future coupons — but it should affect them the same way,” Khorrami said. (The “discount rate” is the rate used to calculate the present value of future cash flows — in that case, stock dividends on stocks and bond interest payments.)

Instead, the researchers observed that stocks and bonds often diverged following the Fed’s decision, especially in Fed meetings that were less about the short rate and more about other policies.

To capture this, they compared price movements in stock-index futures and long-term Treasury futures (proxies for the underlying assets) during the 30-minute window around the Fed announcement.

“We picked 30 minutes because we wanted to isolate the results from unrelated news,” Khorrami said. “This way, we could strictly see the effects of Fed announcements on the beliefs of markets.”

They found that especially during the financial crisis and in the years after, the prices of stocks and long-term bonds moved either the opposite way or, even when they moved in the same direction, the size of the movements differed.

“The correlation between them was low, and the direction of movement was often opposite, which is hard to reconcile with a Fed that is neutral in the long run,” Khorrami said.

Affecting risk aversion, regardless of interest rates

The researchers hypothesized that some Fed announcements change the perception of risk in financial markets, affecting stocks — which are particularly influenced by risk aversion — in ways that are not reflected in long term bonds. 

He cited the example of the Fed announcing asset purchases (quantitative easing) or plans to purchase assets in the future. This will signal lower volatility in the markets of those assets.

“Now, investors are willing to take on more risk,” Khorrami said.

“If the risk aversion of market participants goes down, following the Fed’s announcement, stocks obviously go up, and bonds go down because in some sense the capital shifts out of bonds and into stocks. Think of it as a reallocation of your portfolio.” 

In the opposite situation, if risk aversion increased, stock prices could potentially fall and bond prices rise. This is informally called flight to safety or flight to quality. 

Providing confidence to markets

Historically, the researchers’ findings were most apparent in the aftermath of the 2008 financial crisis. During that time, particularly in 2009-2015, they observed the biggest discrepancies between stocks and bonds following Fed announcements.

“There was a ton of uncertainty, and the Fed was trying things,” Khorrami said. “They introduced QE, and they started using forward guidance more actively.”

Initially, he said, there was a lot of uncertainty around whether the Fed could even fix some of the problems. 

When the first large QE was announced in early March 2009, prices of long-term assets rose — both stocks and bonds — but bonds went up much more than stocks.

“With QE, the Fed bought large volumes of long-term bonds and affected interest rates a lot, but the markets still had a lot of uncertainty about this new policy,” Khorrami said.  “At the same time that they are trying to help the economy with a direct intervention, they’re also making people nervous because this is a new policy tool, so the stock market isn’t as excited because investors are nervous.”

But as markets later became more familiar with the QE policy, stocks almost consistently outperformed bonds between in the announcement windows studied, between 2010 and 2015.

“The markets gained confidence about the toolkit,” Khorrami said. “In some sense, this dramatically reduced the uncertainty about the Fed’s reputation.” 

Beyond 2009-2015: conventional policies and smaller toolkit

The researchers found that outside the 2009 – 2015 period, despite some ups and downs in the stock and bond market reactions to Fed announcements, the overall pattern was more consistent with the long-run neutrality theory.

Intuitively, those were periods when the Fed’s policy was more conventionally focused on interest rates, Khorrami said. 

But reality might be a little bit more nuanced, he added.

“The thing is that even changing the interest rate, depending on how you do it, can offer a lot of learning about the Fed’s mindset.”

He pointed out that the current Fed is intentionally trying to be less transparent about its plans, creating room for uncertainty about its policy playbook.

“This allows the Fed more discretion, which can be good because they can change course whenever they want. This creates increased uncertainty about their rules, which means the markets will have to piece their plans together from their actions, even if they don’t tell us.”

For example, when the Fed raised interest rates in September 2026, despite saying little beforehand, it ended up acting much like the old Fed, Khorrami said.

“It was a textbook policy and a very good learning moment, right?” he said. “Now we have learned that maybe they’re not so different from the standard Fed.” 

He added that even though the days of big asset purchases and active forward guidance may be over — and the primary focus will be the short-term consequences of rate decisions — markets will continue to learn about the Fed from its policies, which will still have big effects on the stock market.

“There will always be this uncertainty channel, where people talk about Fed’s credibility. And whenever [the Fed] might go a little bit out of the comfort zone, that’s when the primary force becomes the uncertainty,” he said. 

“This channel is mostly about communication and is hard to understand because it is very vague, but that’s where most of the action really is,” he said. “All the stock market moves are mostly based on the interpretation of the Fed policy and the uncertainty that they convey, not on interest rates.”