According to our analysis, Fed actions should affect stock prices only to the extent that they affect investor expectations about dividends, short-term real interest rates, or the riskiness of stocks. The trick is to determine quantitatively which of these sets of investor expectations is likely to be most affected when the Fed unexpectedly changes the federal funds rate.
To make this determination, we used a methodology first applied by the financial economist John Campbell, of Harvard University, and by Campbell and John Ammer of the Federal Reserve Board staff (Campbell, 1991; Campbell and Ammer, 1993). Putting the details aside, we can describe the basic idea as follows.