Can the Fed Control Inflation? Stock Market Implications

This paper investigates how the stock market reacts to the Federal Reserve's ability to tame inflation through rate hikes. Since investors do not directly observe the speed at which rate hikes reduce inflation, they need to learn about it by observing inflation prints. When investors realize that the Federal Reserve loses control of inflation, the market risk premium and volatility spike. Furthermore, when the Federal Reserve hikes interest rates following high inflation prints, the stock market crashes, and both the market risk premium and volatility surge. We test these theoretical predictions and show that they find strong empirical support