Monday, May 13, 2013

Monetary Policy and Equity Prices at the Zero Lower Bound

A recent Wall Street Journal article by Jon Hilsenrath raises the question of what will happen to stock and bond prices when the Fed ends its bond-buying program. Tim Duy responds that "Fears of an imminent policy-driven collapse in equity prices are likely greatly over-exaggerated." Duy plots time series of the S&P500 alongside time series of the fed funds rate, noting "it strikes me that previous instances of tighter monetary policy did not trigger immediate widespread declines in equities."

Of course, these previous instances of tighter monetary policy occurred away from the zero lower bound (ZLB), with the target fed funds rate well above zero. Since the end of 2008, with the target fed funds rate at effectively zero, the Fed has attempted to influence interest rates through non-traditional actions such as forward guidance and balance sheet expansion aimed at altering long-term interest rates. If non-traditional expansionary monetary policy has a different effect on equity prices than traditional policy, than non-traditional contractionary monetary policy (i.e. and end to bond-buying) could have a different effect on equity prices than raising the fed funds rate.

How do equity prices react to monetary policy at the ZLB? This is the subject of a Federal Reserve Discussion Series paper by Michael Kiley, "The Response of Equity Prices to Movements in Long-term Interest Rates Associated With Monetary Policy Statements: Before and After the Zero Lower Bound." Kiley studies the impact on equity prices (S&P500) of a monetary policy action that would reduce the 10-year Treasury yield by 100 basis points, both before and during the ZLB era. The key finding is:
Implementation of our identification strategy suggests that, prior to 2009, monetary policy actions that would reduce the 10-year Treasury yield by 100 basis points were associated with a 6- to 9-percent increase in equity prices. In contrast, similar-sized declines in the 10-year Treasury yield associated with monetary policy actions since the end of 2008 have been accompanied by increases in equity prices of 1-½ to 3-percent - a notably smaller association.
The identification strategy is an event-study combined with instrumental variables, focusing on changes in interest rates and equity prices in 30-minute windows around FOMC announcements. The results suggest that non-traditional monetary policy has substantially different--less intense--effects on equity prices than traditional monetary policy. The study only focuses on expansionary actions at the ZLB, by necessity, but if expansionary policy at the ZLB does not cause equity prices to rise as much, then maybe contractionary policy at the ZLB will not cause equity prices to fall as much.
Kiley adds this note:
It is possible that FOMC announcements in the ZLB period have communicated more information about the economic outlook than about the policy stance: If FOMC communications provided previously unappreciated information about the outlook, then it is possible that such information would attenuate the response of equity prices to a policy announcement (because, for example, announcements communicating an easing in policy also communicated a worse economic outlook, with the former factor boosting equity prices and the latter factor depressing equity prices.)
Correspondingly, when the FOMC announces the end of its bond-buying program, that could communicate both a tightening in policy and a better economic outlook. If the announcement makes market participants realize that the economic outlook is better than they thought, that would help boost equity prices. The big question is how much tightening it will indicate. Scaling back asset purchases is tightening in and of itself, but probably not enough to cause a collapse in equity prices. But if the announcement also makes market participants expect a series of interest rate hikes to soon follow, then the depressing effect on equity prices will be much greater. Tim Duy adds in another post that "A challenge for the Fed is that asset purchases are at least in part a communications device that signals commitment to a given policy path. Thus, the Federal Reserve will need to take care to avoid the impression of imminent rate hikes as they scale back asset purchases."


  1. Paine/stopmebeforeyouvoteagain.orgMay 14, 2013 at 7:54 AM

    Read greenwald stiglitz
    Toward a new paradigm in monetary economics
    It will stretch your frames
    And bust a few of your Fetishized modeling toys

  2. Just FYI on the effect of inflation expectations on stock prices:

    Saw your comment on Tim Duy's blog. I commented as well.

  3. Thanks David. I looked at your post and the graph is quite intriguing. For the regressions, though, lots of omitted variable bias, serial correlation, etc. to worry about before putting much faith in the regression results. You say "inflation expectations have driven stock valuations for the last nine years." I say they're correlated, but don't see one driving the other from the info provided in the post. Can you make the graph separately for different time periods (decades)? Also try controlling for growth. And try running as diff in diff.

  4. That's all the data that I had at the time. There are 16 months more now -- I could see how well it tracked.

    As for causation, no, I didn't do anything with Granger causality -- don't have the software for that. Theoretically, though, causation flows from inflation expectations to the stock market through an increase in pricing power. It would be weird to think of it opposite direction.

    As for omitted variable bias &serial correlation, there is a bigger problem that my analysis does not have -- specification searches. I only touched the data once.

    Too many economic papers torture the data until it confesses. It's even worse on Wall Street. As it stands, what I did was more valid than what many economists put out for that reason. Simplicity & lack of a specification search is worth a lot.

  5. Then again, I can say what happened since then -- the S&P 500 rallied 350 points, and the model would have predicted 80. Looks like a fail in the short run.

  6. David, while I agree that torturing the data with specification searches should be avoided, I think there is often justification to do more than just an OLS regression of Y on X. In this case I think theoretically it is more likely that causation flows from an omitted variable to both inflation expectations and stocks, than directly from one to the other. If both have historically been procyclical, but now long-run inflation expectations are less procyclical due to anchoring, that would explain why the S&P rallied less than your model predicted.


Comments appreciated!