Monetary policy expectation errors

How are financial markets pricing the monetary policy outlook? We use surveys to decom-pose excess returns on money market instruments into expectation errors and term pre-mia. Excess returns are primarily driven by expectation errors, whereas term premia are negligible. Investors face challenges when learning about the Federal Reserve's response to large, but infrequent, negative shocks in real-time. Rather than reflecting risk compen-sation, excess returns stem from investors underestimating how much the central bank eases policy in response to such rare shocks. We show, for the US and internationally, that expectation errors imply excess return predictability from past stock returns.(c) 2022 Elsevier B.V. All rights reserved.