On Stock Market Returns and Monetary Policy

Abstract

Financial economists have long debated whether monetary policy is neutral. This article addresses this question by examining how stock return data respond to monetary policy shocks. Monetary policy is measured by innovations in the federal funds rate and nonborrowed reserves, by narrative indicators, and by an event study of Federal Reserve policy changes. In every case the evidence indicates that expansionary policy increases ex-post stock returns. Results from estimating a multi-factor model also indicate that exposure to monetary policy increases an asset's ex-ante return. THE ISSUE OF MONETARY neutrality has long been debated by financial econo-mists. Rozeff (1974) presents evidence that increases in the growth rate of money raises stock returns. Black (1987), on the other hand, argues that monetary policy cannot affect interest rates, stock returns, investment, or employment. Boudoukh, Richardson, and Whitelaw (1994) state that whether monetary policy affects the real economy, and whether its effects are quantitatively important, remain open questions.This article addresses these questions by examining the effects of monetary policy innovations on stock return data. Theory posits that stock prices equal the expected present value of future net cash flows. Thus evidence that positive monetary shocks increase stock returns indicates that expansionary monetary policy exerts real effects by increasing future cash flows or by decreasing the discount factors at which those cash flows are capitalized.To examine the relationship between monetary policy and stock returns, a variety of empirical techniques are employed. Impulse-response functions and variance decompositions from a vector autoregression indicate that there is a large and statistically significant relationship between either negative shocks to the federal funds rate or positive shocks to nonborrowed reserves and subsequent increases in stock returns. Generalized method of moments estimation reveals that narrative evidence of a monetary expansion is also strongly correlated with increases in stock returns. An event study of changes by the Federal Reserve in its federal funds rate target provides additional evidence that a monetary expansion increases stock returns. Finally, nonlinear seemingly unrelated regression estimation of a multifactor model indicates that monetary policy, as measured both by federal funds rate innovations and * The Jerome Levy Economics Institute of Bard College and George Mason University. I am grateful to Ren6 Stulz (the editor) and to an anonymous referee for helpful comments. I also thank Jacob Boudoukh for kindly providing the industry stock return data. 636The Journal of Finance by narrative measures, is a common factor and that assets must pay positive risk premia to compensate for their exposure to it. These results support the hypothesis' that monetary policy, at least in the short run, has real and quantitatively important effects on the economy.1 The vector autoregression (VAR) methodology has proven useful for investig...

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

“…Both approaches commonly use shocks in the federal funds rate (FFR) as the proxy for monetary policy surprises and find that tightening shocks are associated with a significant decline in stock prices. The response is stronger for smaller stocks, consistent with the "sizeeffect" of monetary policy actions (Thorbecke, 1997;Ehrmann and Fratzscher, 2004;Jansen and Tsai, 2010; Kontonikas and Kostakis, 2013; Maio, 2014). Furthermore, the monetary policy effect on stock prices is found to be stronger during bad economic times and in bear markets (Basistha and Kurov, 2008;Jansen and Tsai, 2010).…”

“…Moreover, the access of small companies to intermediated capital is restricted, and when the overall supply of bank loans decreases, credit lines for these companies are the first to be cut. Previous studies provide empirical evidence consistent with the "size-effect" of monetary policy, whereby smaller stocks are more exposed to monetary policy shocks (Thorbecke, 1997;Ehrmann and Fratzscher, 2004;Jansen and Tsai, 2010; Kontonikas and Kostakis, 2013; Maio, 2014).…”

“…Moreover, the access of small companies to intermediated capital is restricted, and when the overall supply of bank loans decreases, credit lines for these companies are the first to be cut. Previous studies provide empirical evidence consistent with the "size-effect" of monetary policy, whereby smaller stocks are more exposed to monetary policy shocks (Thorbecke, 1997;Ehrmann and Fratzscher, 2004;Jansen and Tsai, 2010; Kontonikas and Kostakis, 2013; Maio, 2014).The empirical literature investigating the effect of monetary policy shifts on stock valuation, at the market or portfolio level, generally employs one of the following methodologies: an event study approach that focuses on high-frequency (daily or even intraday) reaction to news about monetary policy (Bernanke and Kuttner, 2005; Kurov, 2010; Lucca and Moench, 2015); and a vector autoregressive (VAR) model, typically estimated with monthly data (Thorbecke, 1997;Bernanke and Kuttner, 2005; Kontonikas and Kostakis, 2013). Both approaches commonly use shocks in the federal funds rate (FFR) as the proxy for monetary policy surprises and find that tightening shocks are associated with a significant decline in stock prices.…”

“…The empirical literature investigating the effect of monetary policy shifts on stock valuation, at the market or portfolio level, generally employs one of the following methodologies: an event study approach that focuses on high-frequency (daily or even intraday) reaction to news about monetary policy (Bernanke and Kuttner, 2005;Kurov, 2010;Lucca and Moench, 2015); and a vector autoregressive (VAR) model, typically estimated with monthly data (Thorbecke, 1997;Bernanke and Kuttner, 2005;Kontonikas and Kostakis, 2013). Both approaches commonly use shocks in the federal funds rate (FFR) as the proxy for monetary policy surprises and find that tightening shocks are associated with a significant decline in stock prices.…”

Causal Relationship between Monetary Policy and the Stock Market: a Bootstrap Rolling Window Approach

“…The recent financial crisis has enhanced the importance to study the relationship between the monetary policy and stock market (Thorbecke, 1995). It is significant to evaluate the impact of the future course of action in the economy.…”