Monetary Policy and its Effects on Stock Markets - Essay Example

Monetary Policy and its Effects on Stock Markets TOPIC PAGE NO Introduction 01 2. The Monetary Policy 01 3. Research Methodology 02 4. The Effects of Monetary Policy on Stock Markets 03 5. Conclusion 08 6. References 10 Introduction. Catastrophe of 1987 - On October 19, 1987 the stock market alongwith the associated futures and options market crashed, with the S&P 500 stock market index falling about 20 per cent. Allthough the markets recovered quickly after this crash, it was the effort of the Federal Reserve which restored the confidence of the investors in the U.S. stock market. In the following study, we will ascertain the importance of the Monetary Policy and its effect on the stock markets. The Monetary Policy. Inflation - Inflation simply means, the increase in price of goods and services in the country. During a state of inflation, the purchasing power of money decreases. The effects of inflation are harmful for the economy. Not only does it affect the economy, but also tends to affect the value of stocks, since money loses its value. Higher inflation would tend to depress stock returns because it would raise long-term interest rates (and thereby raise the rate at which investors discount future dividends). Monetary Policy - Monetary Policy is a means to control inflation, one of the corrective tools of the Central Bank of a country. Presence of inflation in the current market and expected future requires the need for such a policy to ensure that inflation rates do not go above a specific percentage thus acting as a tool to curb inflation. A few tools of the Monetary Policy include 1. Inflation Targeting - Inflation targeting is a policy that is implemented to keep inflation under a particular range. It targets the Consumer Price Index (CPI) which measures the average price of consumer goods and services purchased by households. A change in the CPI is an indicator to inflation hence inflation targeting aims at maintaining the CPI within a specific range. 2. Price Level Targeting - It is similar to inflation targeting, the only difference is the CPI growth in one year is offset in subsequent years so that over time, the price level on aggregate does not move. Research Methodology. Despite claims that monetary policy should not affect stocks, there is evidence that the policy can affect real stock prices in the short run (Bernanke & Kuttner 2005) and also an opinion that the nature of the monetary policy regime can affect the performance of asset markets over longer horizons. It has also been observed that by altering the path of expected dividends, the discount rate or the equity premium is one of the effects of the monetary policy on stocks1 Observers of Financial Markets have noted that an unexpected decrease in the federal funds rate target leads to a rapid and positive reaction in stock prices thus implying the effect of the Monetary Policy on Stock Markets. Research Methodology - Our research methodology includes secondary data indicating the effect of policies on stock markets. We shall also examine the behaviour of important macroeconomic and monetary policy variables during stock market booms which will lead us to understanding the effect of macroeconmic policies like the Monetary Policy on Stock markets. The effects of Monetary Policy on Stock Markets. Monetary Policy Tools that affect stock prices Discount Window Lendings - The Monetary Authority can directly change the size of money supply by using the Discount Window tool. By calling in existing loans or extending new loans, the money supply in the country is regulated. When the money supply is ample, investors look to investments and when money supply is low, invetments are diluted to increase liquidity. Thus Discount Window Lendings influences stock prices. Reserve Requirement - A certain reserve of their assets is meant to be held by the Central Banks which is for withdrawals and the remainder is normally invested in mortgages and loans. A change in the reserve requirement either increases the holdings and reduces loans and mortgages or decreases the same thereby indirectly affecting stock prices. Open Market Operations - Purchase and Sales of US Treasury and Federal Agency securities is the principle tool for implementing Monetary Policy thus controlling the money flow. A change in the Open market operations increases or decreases volumes of trade which also affects stock prices. Guo analyzes the stock market reaction to unanticipated changes in th Federal funds rate target from 1974 - 79 and 1988 - 2000. Business conditions in the 70s were not favourable in the U.S. where the economy suffered from a severe recession and high inflation after the 1973 oil crisis which displays the prices of stocks which fell steeply due to prevailant economic conditions, whereas in the 1990s, the United States enjoyed the longest economic expansion since World War II which according to the diagram indicates a healthy position of the stock market. The 2 periods shown above in the digram provide an opportunity to investigate the asymmetric effect of monetary policy on equity prices. According to Bernanke and Kuttner (2005) ,during 1989 - 2002 an uncapacitated 25 point increase in the Federal Reserve's target for federal funds rate or the interest rate at which the federal bank lends funds to other depository institutions produced a 1 per cent decline in equity prices in the U.S. Stock market providing another instance of the effect of the monetary policy on stock prices. Inflation tends to depress stock returns because long-term interest rates would rise in response to higher expected inflation and demand implementation of a tighter monetary policy which would also slow economic activity and thereby reduce current and future corporate earnings ultimately reducing investments and affecting stocks. A reversal of policy in response to a weak economy and lower inflation would tend to reduce interest rates and boost stock returns. Therefore policy actions that result in increasing liquidity cause asset prices to fall and lesser liquidity caues asset prices to rise. Shocks - Shocks are identified through the following indicators a. Industrial Production b. Inflation c. Money Stock Growth d. Long term treasury yield e. Short term interest rate f. Real stock price index Shocks effect the economy. An increase in Industrial Production leads to economic growth and liquidity. A growth in liquidity cuts inflation and inadvertently affects stock prices. A similar effect can be attributed to the abovementioned points which has an effect on the stock market. The U.S. Stock Market boomed from 1994 till 2000 and analysts attributed this boom to advances in information processing technology and increased productivity growth. Both the GDP and productivity growth during that period were high whereas inflation was low. Factors like labour productivity growth, GDP growth, and increase in technology sectors attributed to the stock market boom. These factors convinced many observers that corporate profits would continue to grow rapidly and thereby justified soaring equity prices. Further, shrinking government budget and low inflation suggested that interest rates would remain low. From Figure 3 (displayed below) we can attribute a change in the stock market to the increase in GDP and Productivity. Stock market booms often ended following an increase in inflation and a tightening of monetary conditions thereby indicating that a rise in inflation or implementing Central Bank corrections like the Monetary Policy inadvertently affect the prices of stocks and the market. The above figure plots monthly data on CPI (Consumer Price Inflation) during the U.S. boom of 1994-2000, as well as the median across all post-1970 booms. The figure shows that inflation was below its long-run average throughout the 60 months preceding the August 2000 peak in U.S. real stock prices. Further, the figure shows a decline in the inflation rate that occurred in 1997 and early 1998 (months "44" to "29") and an increase during 1999 and the first half of 2000 (approximately the last 20 months of the boom period). Across all post-1970 booms,median inflation was below average and declining until some 12 months before a stock market peak month, when inflation began to rise. Thus, both the U.S. stockmarket boomof 1994-2000 and the "typical"post-1970 boom arose when inflation was below average and ended after several months of rising inflation.The U.S. stock market boom of 1994-2000 attracted considerable attention from Federal Reserve officials and other policymakers. Fed officials feared that rapid gains in stock market wealth would cause rapid growth in spending and inflation, but officials were perhaps even more concerned that a sudden decline in the market could lead to a recession.2 Conclusion The early effects of the monetary policy can be observed when asset prices tend to focus on the impact of changes in liquidity on the demand for various assets that compromise the portfolio of the Private Sector. Extended periods of rapidly appreciating equity housing and other asset prices in the United States and elsewhere since the mid 1990s have increased attention towards the effects of monetary policy on asset markets thus we can conclude that 20th century stock market booms typically were associated with the business cycle arising when output (real gross domestic product GDP) growth was above average and ended as output growth slowed showing the effect of economic policies which affect stock markets. Nations that use Monetary Policy: Australia - Inflation Targeting Canada - Inflation Targeting Eurozone - Inflation Targeting United Kingdom - Inflation Targeting3 United States - Mixed Policy4 The above shows the application of Monetary Policy in various countries as a measure to control inflation thus implifying that stock markets globally are affected by Monetary Policy. References Bordo, Micheal and Wheelock, David - Stock Market Booms and Monetary Policy in the Twentieth Century. Monetary Trends, Why do stock markets react to the Fed http://research.stlouisfed.org/publications/mt/20040701/cover.pdf Carlson, Mark - A brief history of the 1987 Stock Market Crash (Nov 2006) Bordo, Micheal, Dueker, Micheal and Wheelcock, David - Working Paper 2007-020A http://research.stlouisfed.org/wp/2007/2007-020.pdf http://federalreserve.gov/fomc/fundsrate.htm Read More