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."