First, this research suggests that relatively small changes in
monetary policy would not do much to curb a major overvaluation in
the stock market. As we have seen, a surprise tightening of 25 basis
points should be expected to lower stock prices by only a little more
than 1 percent, which, as already noted, is a trivial movement
relative to the overall variability of the stock market. It would not
be appropriate to extrapolate these results to try to estimate how
much tightening would be needed to correct a substantial putative
overvaluation in stock prices, but it seems clear that a light
tapping of the brakes will not be sufficient. What we can say is that
the necessary policy move would have to be quite large--many
percentage points on the federal funds rate--and we would be highly
uncertain about its magnitude or its ultimate effects on stock prices
and the economy.15,16
Second, we have seen that monetary tightening reduces stock prices
primarily by increasing the risk premium for holding stocks, as
opposed to raising the real interest rate or lowering expected
dividends. The risk premium for stocks will rise only to the extent
that broad macroeconomic risk rises, or that people experience
declines in income and wealth that reduce their ability or
willingness to absorb risk (Campbell and Cochrane, 1999). This
evidence supports the proposition that monetary policy can lower
stock values only to the extent that it weakens the broader economy,
and in particular that it makes households considerably worse off.
Indeed, according to our analysis, policy would have to weaken the
general economy quite significantly to obtain a large decline in
stock prices.
Conclusion
I have reported today on empirical work, by my coauthor and me as
well as by others, about the links between monetary policy and the
stock market. I have only touched on a large literature, and I
apologize to the many researchers whose work I have not been able to
describe today. But I hope that I have given you a flavor of how
empirical research can help us to refine our understanding of how
monetary policy works and how policy should be conducted.
REFERENCES
Bernanke, Ben (2002). "Asset-Price 'Bubbles' and Monetary Policy."
Speech before the New York chapter of the National Association for
Business Economics, New York, New York, October 15.
Bernanke, Ben and Mark Gertler (1995). "Inside the Black Box: The
Credit Channel of Monetary Transmission," Journal of Economic
Perspectives, 9 (Fall), pp. 27-48.
Bernanke, Ben and Mark Gertler (2001). "Should Central Banks Respond
to Movements in Asset Prices?", American Economic Review, 91 (May),
pp. 253-57.
Bernanke, Ben and Kenneth Kuttner (2003). "What Explains the Stock
Market's Reaction to Federal Reserve Policy?" Working paper, Federal
Reserve Bank of New York, October.
Campbell, John (1991). "A Variance Decomposition for Stock Returns,"
Economic Journal, 101 (March), pp. 157-79.
Campbell, John, and John Ammer (1993). "What Moves the Stock and Bond
Markets? A Variance Decomposition for Long-Term Asset Returns,"
Journal of Finance, 48 (March), pp. 3-37.
Campbell, John, and John Cochrane (1999). "By Force of Habit: A
Consumption-Based Explanation of Aggregate Stock Market Behavior,"
Journal of Political Economy, 107 (April), pp. 205-51.
D'Amico, Stefania, and Mira Farka (2002). "The Fed and the Stock
Market: A Proxy and Instrumental Variable Identification." Working
paper, Columbia University.
Greenspan, Alan (2002). "Economic Volatility." Speech before a
symposium sponsored by the Federal Reserve Bank of Kansas City,
Jackson Hole, Wyoming, August 30.
Guo, Hui (2002). "Stock Prices, Firm Size, and Changes in the Federal
Funds Rate Target." Working paper, Federal Reserve Bank of St. Louis,
January.
Gürkaynak, Refet, Brian Sack, and Eric Swanson (2002). "Market-Based
Measures of Monetary Policy Expectations." Working paper, Board of
Governors of the Federal Reserve System, June.
Krueger, Joel, and Kenneth Kuttner (1996). "The Fed Funds Futures
Rate as a Predictor of Federal Reserve Policy," Journal of Futures
Markets, 16 (December), pp. 865-79.
Kuttner, Kenneth (2001). "Monetary Policy Surprises and Interest
Rates: Evidence from the Fed Funds Futures Market," Journal of
Monetary Economics, 47 (June), pp. 523-44.
Lettau, Martin, and Sydney Ludvigson (2001). "Consumption, Aggregate
Wealth, and Expected Stock Returns," Journal of Finance, 56 (June),
pp. 815-49.
Lettau, Martin, and Sydney Ludvigson (2002). "Time-Varying Risk
Premiums and the Cost of Capital: An Alternative Interpretation of
the Q Theory of Investment," Journal of Monetary Economics, 49
(January), pp. 31-66.
Ludvigson, Sydney, Charles Steindel, and Martin Lettau
(2002). "Monetary Policy Transmission through the Consumption-Wealth
Channel," Federal Reserve Bank of New York, Economic Policy Review, 8
(May), pp. 117-133.
Owens, Raymond and Roy Webb (2001). "Using the Federal Funds Futures
Market to Predict Monetary Policy Actions," Federal Reserve Bank of
Richmond, Economic Quarterly, 87 (Spring), pp. 69-77.
Poole, William, Robert Rasche, and Daniel Thornton (2002). "Market
Anticipations of Monetary Policy Actions," Federal Reserve Bank of
St. Louis, Review, 84 (July/August), pp. 65-93.
Rigobon, Roberto, and Brian Sack (2002). "The Impact of Monetary
Policy on Asset Prices," Finance and Economics Discussion Series 2002-
4, Board of Governors of the Federal Reserve System, January.
Sack, Brian (2002). "Extracting the Expected Path of Monetary Policy
from Futures Rates," Finance and Economics Discussion Series 2002-56,
Board of Governors of the Federal Reserve System, December.
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Footnotes
1. Bernanke and Kuttner (2003);
home.earthlink.net Return to
text
2. The futures contract is based on monthly averages of the federal
funds rate, so that some manipulation is needed to obtain the daily
expectations of the funds rate used in this paper. See Bernanke and
Kuttner (2003) or Kuttner (2001) for further details. Allowing for
risk premiums creates another complication; see Sack (2002). I ignore
these technicalities here.Return to text
3. Other financial instruments, such as eurodollar futures rates, can
and have been used to forecast changes in the federal funds rate.
Although each of the various alternatives has advantages, Gürkaynak,
Sack, and Swanson (2002) find that the federal funds futures rate is
the best predictor of monetary policy actions for horizons out to
several months. Return to text
4. The beginning of the sample corresponds to the availability of the
futures data. We excluded the observation corresponding to September
17, 2001, the first day of trading following the September 11
terrorist attacks. Return to text
5. That the Federal Reserve has only been formally announcing its
policy moves since 1994 added a measure of complexity to our
research. Before then, market participants generally did not become
aware of the FOMC's policy decisions until those decisions were
actually implemented in the market for bank reserves, often the day
after the FOMC decision. To the extent possible, we dated the policy
change as of the day that the market would have become aware of it,
not the day of the decision itself. See the paper for details. Return
to text
6. Investors would not literally expect the Fed to cut the funds rate
by 31 basis points, since the Fed usually moves in 25-basis-point
increments. An average expectation of a 31-basis-point cut would be
consistent with, for example, 62 percent of investors expecting a 50-
basis-point and 38 percent expecting no cut. Return to text
7. In principle, news other than the policy decision might affect the
federal funds futures contract during the day, so that the measure of
unanticipated policy changes we use here might be a "noisy" one. If
so, our approach would underestimate the effect of policy changes on
the stock market. However, Poole, Rasche and Thornton (2002, pp. 68-
69) perform an analysis that suggests that the mismeasurement may be
small in practice. Further confirmation is provided by D'Amico and
Farka (2002), who find results similar to ours using ten-minute
windows around the announcement; the benefit of a tight window is
that the policy announcement is highly likely to dominate movements
in the contract over that period. Return to text
8. Technically, we removed outlier observations based on their so-
called influence statistics, which measure the importance of
individual observations to the overall results. Another correction
was needed because, in the early part of the sample, particularly
between 1989 and 1992, it was not uncommon for intermeeting rate cuts
to take place on the same day that the government issued weaker-than-
expected reports about employment growth. In such cases, our method
cannot distinguish cleanly between the effects of the employment news
and the effects of the rate cut itself on the stock market. If we
eliminate both the outlier observations and the observations in which
employment reports coincided with rate changes, we find the
multiplier effect of policy changes on the stock market to be about
3.6 and again statistically significant. Return to text
9. To focus on policy surprises of longer duration, Rigobon and Sack
(2002) derive their measure of the unexpected policy change on the
three-month eurodollar deposit rate, rather than the current month's
federal funds rate, as in this paper and in Kuttner (2001). Using a
methodology that also attempts to correct for two-way causality
between the funds rate and asset prices, and data for post-1993
scheduled FOMC meetings and Chairman's testimony dates only, they
find comparable though slightly higher values for the effect of
monetary policy on the stock market. For example, they find a policy
multiplier for the Standard and Poor's 500 index of 7.7. However,
when they use data on the federal funds rate futures market to
measure policy shocks, Rigobon and Sack find results similar to ours,
using their sample and methodology. Return to text
10. Using methods similar to ours, Guo (2002) found that the impact
of monetary policy actions on stock prices does not seem to depend on
firm size. Return to text
11. The existence of a large equity premium in the past is, of
course, no guarantee of an equally large equity premium in the
future. The fact that equities are more widely held today than in the
past, implying that the risk of equities is more widely shared, is
one reason that the equity premium may be lower in the future than it
has been in the past. Return to text
12. Of course, a looming recession is likely also to lower expected
dividends (bad for stocks) and lower interest rates (good for
stocks). Generally, stock prices are a leading indicator, falling
ahead of recessions and rising in advance of recoveries (although
with many false signals). Return to text
13. Variables used in our forecasting model, besides the excess
return on stocks, the one-month real interest rate, and the
unanticipated change in the funds rate, include the relative bill
rate (defined as the three-month Treasury bill rate minus its 12-
month moving average), the change in the bill rate, the smoothed
dividend-price ratio, and the spread between 10-year and one-month
Treasury yields. Return to text
14. There is a bit more to this analysis. An additional complexity
arises from the fact that, although easier monetary policy allows
consumers to enjoy a capital gain in their stock portfolios today, it
also "takes back" some of that gain, so to speak, by affording
shareholders a lower rate of return on their holdings, on average, in
subsequent periods. Research by Sydney Ludvigson and Martin Lettau of
New York University and Charles Steindel of the Federal Reserve Bank
of New York (Ludvigson, Steindel, and Lettau, 2002; Lettau and
Ludvigson, 2001) suggests that, because the gain in share prices
induced by a monetary easing is partly transitory, consumers will not
increase their spending in response to stock price changes induced by
monetary policy as much as they will in response to stock price
changes induced by other factors. The estimates in our paper suggest
that this differential effect will be relatively small, however.
Also, to the extent that the capital gains induced by monetary policy
are perceived as partly transitory, the short-run response of
investment spending will be strengthened, as firms prefer to invest
while stock prices remain high; see Lettau and Ludvigson, 2002, for
evidence. In short, if changes in stock values induced by monetary
policy are perceived as relatively more transitory, the effects of
policy will be concentrated more on investment spending and less on
consumption spending than the conventional wisdom suggests. Return to
text
15. Greenspan (2002) notes several episodes in which increases in the
federal funds rate of several hundred basis points did not materially
slow stock appreciation. He argues that "such data suggest that
nothing short of a sharp increase in short-term rates that engenders
a significant economic retrenchment is sufficient to check a nascent
bubble." The late Fischer Black once defined an efficient stock
market as one in which prices are between half and double fundamental
values; if Black's view is to be believed, then identifiable
deviations of prices from fundamentals would have to be quite large
indeed. Return to text
16. Implicitly I am considering here the case of a central bank that
responds only sporadically to stock prices, in those situations in
which it perceives a bubble to be forming. Irregular deviations from
a policy rule focused on output and inflation seem appropriately
modeled as unanticipated movements in policy. An alternative policy
strategy would be to incorporate regular reactions to stock values
into the systematic part of the monetary policy reaction function.
That strategy has some advantages, but it has the important
disadvantage that it does not discriminate between fundamental and
nonfundamental sources of changes in stock values. Bernanke and
Gertler (2001) present simulations showing that such a strategy is
unlikely to be beneficial in terms of overall macroeconomic
stability. |
