Monetary Policy Responds to Stock Market Movements - Dissertation Example

 Monetary Policy Responds to Stock Market Movements Research Aims The aim of this study is to determine whether monetary policy responds to stock market movements. It describes the theory of monetary policy and looks at the interrelationships between stock market movements and monetary policy. It reviews a number of related studies and seeks to analyse relevant data in order to arrive at a conclusion. A description of the relevant data that is to be used in the study is given along with the research methodology that will be employed in carrying out the study. In addition to works cited in the literature review other studies that are helpful are also included in the list of references. Theoretical and Empirical Framework The goals of monetary policy are to achieve price stability and sustainable economic growth that maintains a stable price system. The main instrument of monetary policy is interest rate. According to Fuhrer and Geoff (2004) recent work suggests that stock market prices have affected monetary policy decisions. However, there are other studies that have indicated that the correlation between stock price movements and other variables have made it very problematic to identify the stock price effect. It is therefore extremely difficult to separate the relationship between changes in equity values and monetary policy because of the simultaneous interactions among the real economy, stock prices, and monetary policy actions. Literature Review According to Bernanke and Gertler (2001) changes in asset prices (including stock prices) should only impact monetary policies to the extent that they affect the central banks forecast of inflation. Therefore, the target of monetary policy is inflation and not specifically stock prices. Hayford and Malliaris (2002) used different methodologies to determine whether monetary policy has influenced the stock market since it crashed on October 19, 1987. The results indicate that, rather than using the Federal Funds rate policy to offset increases in the value of the stock market above estimates of fundamentals, Federal Fund policy has on average accommodated what is considered to be overvaluation of the stock market. Hayward and Malliaris (2002) found evidence in the FOMC minutes which is consistent with Taylor (1993). Taylor’s (1993) rule suggests that Federal Funds rate target has largely been st in response to inflation and measures of excess demand and therefore is not solely a response to offset potential stock market valuations. Rigobon and Sack (2003) employed an identification technique based on the heteroskedasticity of stock market returns in order to determine the response of monetary policy to stock market movements. Using daily and weekly movements in interest rates and stock prices between 1985 and 1999 Rigobon and Sack (2003) found that the response of monetary policy to stock market movements was significant. The results showed a 5% rise (fall) in the Standard and Poor’s (S&P) 500 Index, increasing the possibility of a 25 basis point tightening (easing) by about one half. These results suggest that stock market movements have a significant impact on short term interest rates, driving them in the direction as the change in stock prices. This Rigobon and Sack (2003) attribute to the anticipated reaction of monetary policy to stock market increases. Fuhrer and Tootell (2004) focused on the fact that methods used in earlier literature fail to adequately separate what they describe as the observational equivalence problem. In addition Fuhrer and Tootell (2004) showed that after controlling for the information that that enters the Federal Open Market Committee’s (FOMC’s) decision making process stock market prices have had no independent effect on monetary policy. Cassala and Morena (2004) made several conclusions from their study. Among them were the fact that stock market prices and asset prices in general plays an important role in the transmission mechanism in the euro area. They also found no significant direct impact of stock prices on inflation. Taking the above points together Cassala and Morena (2004) suggest that stock market prices may be of some importance to monetary policy which is independent of their direct impact on monetary policy. Research Methodology In order to determine whether monetary policy responds systematically we combine Taylor’s (1993) monetary policy rule with a target for the stock market. The regression model will seek to determine whether the null hypothesis that monetary policy is not dependent on stock market movements can be accepted or rejected for the alternative hypothesis. Quarterly stock market data from November 1987 to October 20010 will be used in this research. Description of data The model that will be used to test the hypothesis is: Rt = πt + r* + α1(πt – π*) + α2yt + α3(ρt – ρ*) where R – is the current nominal central bank interest rate π – is the average inflation rate π* - is the target inflation rate r* - is the long run equilibrium real central bank interest rate y – is the output gap ρt – a measure of stock market valuation ρ*- the target stock market value Results and Findings If α1 > 0 then monetary policy is stable and offsets increases in inflation by increasing r* Where ρt represents the price earnings ratio then if ρt > ρ* then monetary policy that aims to reduce ρt would seek to increase Rt and so α3 > 0 α3 < 0 if monetary policy is contributing to a stock market bubble Where ρt represents the equity premium If ρt < ρ* then monetary policy that aims to reduce the estimated bubble would seek to decrease Rt and so α3 < 0. If monetary policy however, seeks to accommodate a stock market bubble then α3 > 0. Conclusion and Limitations A conclusion is arrived at based on the results and findings and a determination will be made on whether to accept the null hypothesis or to reject it in favour of the alternative hypothesis. Limitations that impact the study will also be highlighted. References Laopodis, N.T. (2006). Dynamic Linkages between Monetary Policy and the Stock Market. Journal of Business and Economics Research: 4(12). p. 31- Rigobon, R and Sack, B. (2003). Measuring the Reaction of Monetary Policy to the Stock Market. The Quarterly Journal of Economics: 118(2). p. 639-669 Cassala, N. and Morena, C. (2004). Monetary Policy and the Stock Market in the Euro Area. Journal of Policy Modeling: 26(2004). Hayford, M.D and Malliaris, A.G. (2002). Monetary Policy and the U.S. Stock Market. Bernanke, B.S. and Gertler, M. (2001). Should Central Banks Respond to Movements in Asset Prices. The American Economic Review: 91(2). p. 253-257. Fuhrer, J. and Tootell, G. (2004) Eyes on the Prize: How Did the Fed Respond to the Stock Market. Public Policy Discussion Papers. Federal Reserve Bank of Boston Johnson, M.H. (1988). Current Perspectives on Monetary Policy. Cato Journal: 8(2) Ioannidis, C. and Kontonikas, A. (2006). The Impacy of Monetary Prices on Stock Prices. Taylor, John (1993). Discretion versus Policy Rules in Practice. Carnegie-Rochester Conference Series on Public Policy 15:151-200. Clarida,R., Gali J., and Gertler, M. (2000). Monetary policy rules and macroe- conomic stability: evidence and some theory. The Quarterly Journal of Economics: p.147-180, 2000. Read More