Monetary policy and stock valuation: structural VAR identification and size effects

Abstract

This paper examines the relationship between the US monetary policy and stock valuation using a structural VAR framework that allows for the simultaneous interaction between the federal funds rate and stock market developments based on the assumption of long-run monetary neutrality. The results confirm a strong, negative and significant monetary policy tightening effect on real stock prices. Furthermore, we provide evidence consistent with a delayed response of small stocks to monetary policy shocks relative to large stocks. § Corresponding author. Essex Business School, Finance Subject Group, University of Essex, Colchester, CO4 3SQ, UK, a.kontonikas@essex.ac.uk.‡ Adam Smith Business School, University of Glasgow, Glasgow, G12 8QQ, UK, z.zekaite.1@research.gla.ac.uk. We would also like to thank Tom Doan for providing the estimation code and helpful advice. 2 IntroductionFinance practitioners and academic researchers generally agree that monetary policy shifts have strong effects on financial markets and that there may be the role for asset prices in the monetary policy reaction function. 1 The empirical literature investigating the relationship between monetary policy and stock valuation in the United States goes back to 1970s. 2 In these early studies it is acknowledged that causality may run in both directions (Cooper, 1974;Smirlock and Yawitz, 1985). Given that stock prices, amongst other asset prices, feature in the monetary policy transmission mechanism, it is important to gain a thorough understanding of how monetary policy interacts with stock market developments (Mishkin, 2001;Bjornland and Jacobsen, 2013). This paper re-examines this relationship at both the market and portfolio level using data on portfolios formed on the basis of firm's size (market value). The empirical framework that we use allows for the short-run interaction between monetary policy and real stock price developments, assuming long-run monetary neutrality.Monetary policy may affect stock prices through its impact on the expected future net cash flows and the discount rate; the latter being equal to the sum of a risk-free interest rate and a risk premium (Smirlock and Yawitz, 1985; Kontonikas and Kostakis, 2013). According to the traditional interest rate channel, monetary policy tightening lowers the demand for loans due to higher costs of borrowing. In turn, consumption and investment spending decline leading to lower expected future net cash flows and, consequently, to lower current stock prices (Bernanke and Gertler, 1995;Ehrmann and Fratzscher, 2004). The credit channel operates via the impact of monetary policy on the external finance premium (Gertler and Gilchrist, 1994; Gertler, 1995, Kiyotaki and Moore, 1997 3 response to monetary policy tightening, the equity premium on stocks goes up either due to higher perceived riskiness of firms or increased risk aversion among investors. Consequently, current stock prices decline.Smaller firms are typically less immune to adverse conditions stemming from tighter monetary co...

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