Remarks by Governor Ben S. Bernanke
At the Fall 2003 Banking and Finance Lecture, Widener University,
Chester, Pennsylvania
October 2, 2003
Monetary Policy and the Stock Market: Some Empirical Results
The ultimate objective of monetary policymakers is to promote the
health of the U.S. economy, which we do by pursuing our mandated
goals of price stability and maximum sustainable output and
employment. However, the effects of our policy instruments, such as
the short-term interest rate, on these goal variables are indirect at
best. Instead, monetary policy actions have their most direct and
immediate effects on the broader financial markets, including the
stock market, government and corporate bond markets, mortgage
markets, markets for consumer credit, foreign exchange markets, and
many others. If all goes as planned, the changes in financial asset
prices and returns induced by the actions of monetary policymakers
lead to the changes in economic behavior that the policy was trying
to achieve. Thus, understanding how monetary policy affects the
broader economy necessarily entails understanding both how policy
actions affect key financial markets, as well as how changes in asset
prices and returns in these markets in turn affect the behavior of
households, firms, and other decisionmakers. Studying these links is
an ongoing enterprise of monetary economists both within and outside
the Federal Reserve System.
The link between monetary policy and the stock market is of
particular interest. Stock prices are among the most closely watched
asset prices in the economy and are viewed as being highly sensitive
to economic conditions. Stock prices have also been known to swing
rather widely, leading to concerns about possible "bubbles" or other
deviations of stock prices from fundamental values that may have
adverse implications for the economy. It is of great interest, then,
to understand more precisely how monetary policy and the stock market
are related.
In my talk today, I will report the results of research that I have
done on this topic with Kenneth Kuttner of the Federal Reserve Bank
of New York, as well as the findings of some related work done both
within and outside the Federal Reserve System.1 The views I will
express today, however, are my own and not necessarily those of my
colleagues on the Federal Open Market Committee (FOMC) or the Board
of Governors of the Federal Reserve System.
In our research, Kuttner and I asked two questions. First, by how
much do changes in monetary policy affect equity prices? As you will
see, we focus on changes in monetary policy that are unanticipated by
market participants because anticipated changes in policy should
already be discounted by stock market investors and, hence, are
unlikely to affect equity prices at the time they are announced. We
find an effect of moderate size: Monetary policy matters for the
stock market but, on the other hand, it is not one of the major
influences on equity prices.
Our second question, both more interesting and more difficult, is,
why do changes in monetary policy affect stock prices? We come up
with a rather surprising answer, at least one that was surprising to
us. We find that unanticipated changes in monetary policy affect
stock prices not so much by influencing expected dividends or the
risk-free real interest rate, but rather by affecting the perceived
riskiness of stocks. A tightening of monetary policy, for example,
leads investors to view stocks as riskier investments and thus to
demand a higher return to hold stocks. For a given path of expected
dividends, a higher expected return can be achieved only by a fall in
the current stock price. As we will see, this finding has interesting
implications for several issues, including the role of stock prices
in transmitting the effects of monetary policy actions to the broader
economy and the potential effectiveness of monetary policy
in "pricking" putative bubbles in the stock market. I will come back
to these issues at the end of my talk. I start, however, with the
problem of measuring the effect of monetary policy on the stock
market.
The Effect of Monetary Policy Actions on the Stock Market
Normally, the FOMC, the monetary policymaking arm of the Federal
Reserve, announces its interest rate decisions at around 2:15 p.m.
following each of its eight regularly scheduled meetings each year.
An air of expectation reigns in financial markets in the few minutes
before to the announcement. If you happen to have access to a monitor
that tracks key market indexes, at 2:15 p.m. on an announcement day
you can watch those indexes quiver as if trying to digest the
information in the rate decision and the FOMC's accompanying
statement of explanation. Then the black line representing each
market index moves quickly up or down, and the markets have priced
the FOMC action into the aggregate values of U.S. equities, bonds,
and other assets.
On occasion, if economic conditions warrant, the FOMC may decide to
make a change in monetary policy on a day that falls between
regularly scheduled meetings, a so-called intermeeting move.
Intermeeting moves, typically agreed upon during a conference call of
the Committee, nearly always take financial markets by surprise, at
least in their precise timing, and they are often followed by
dramatic swings in asset prices.
Even the casual observer can have no doubt, then, that FOMC decisions
move asset prices, including equity prices. Estimating the size and
duration of these effects, however, is not so straightforward.
Because traders in equity markets, as in most other financial
markets, are generally highly informed and sophisticated, any policy
decision that is largely anticipated will already be factored into
stock prices and will elicit little reaction when announced. To
measure the effects of monetary policy changes on the stock market,
then, we need to have a measure of the portion of a given change in
monetary policy that the market had not already anticipated before
the FOMC's formal announcement.
Fortunately, the financial markets themselves are a source of useful
information about monetary policy expectations. As you may know, the
FOMC implements its decisions about monetary policy by changing its
target for a particular short-term interest rate, the federal funds
rate. The federal funds rate is the rate at which depository
institutions borrow and lend reserves to and from each other
overnight; although the Federal Reserve does not control the federal
funds rate directly, it can do so indirectly by varying the supply of
reserves available to be traded in this market. Since October 1988,
financial investors have been able to hedge and speculate on future
values of the federal funds rate by trading contracts in a futures
market, overseen by the Chicago Board of Trade. Investors in this
market have a strong financial incentive to try to guess correctly
what the federal funds rate will be, on average, at various points in
the future. The existence of a market in federal funds futures is a
boon not only to investors, such as banks, which want to protect
themselves against changes in the cost of reserves, but also to both
policymakers and researchers, because it allows any observer to infer
from the sale prices of futures contracts the values of the federal
funds rate that market participants anticipate at various future
dates.2 Previous research (Krueger and Kuttner, 1996; Owens and Webb,
2001) has shown that participants in this market collectively do a
good job of forecasting future values of the funds rate, efficiently
incorporating available information about likely future monetary
policy actions.3 |
