Monetary policy and the stock market

Money drives the stock market or at least that is the conventional wisdom of investors. Do not fight the Fed. The transmission from a monetary policy change to equity prices can come through three mechanisms. One, there is a change in dividend yield. Two, there is a change in the discount factor. Three, there is a change the level of risk with stocks, the equity risk premium. A lowering of interest rates reduces the discount factor for future earnings and makes bonds less attractive. A cut in the short rate improves the overall economy which effect top-line growth and should improve the dividend yield. Finally, a cut in rates will change the level of riskiness in equities through smoothing out consumption and wealth in the economy which would have a positive impact on stock prices as the equity risk premium declines.

But should monetary policy be used to help the stock market during times of stress? At the extreme, in a liquidity crisis the answer is yes, but what about a situation like last week. Goldman Sachs points to a speech that Ben Bernanke made concerning the interaction between monetary policy and equity prices which we reviewed in detail. It is important reading on research conducted pre-2003.

http://www.federalreserve.gov/boarddocs/speeches/2003/20031002/default.htm

Bernanke focused in the impact on monetary policy and finds that unanticipated monetary policy changes do affect equity prices. There is no surprise here albeit there are other important influences on stocks, yet his research suggests that the impact is actually very modest. His research focused on the unanticipated impact of monetary policy. Specifically, he compared the Fed fund futures forecast versus the actual monetary policy action. This represents the surprise impact which should be the portion of monetary policy that affects equity prices.

The Fed funds futures does a decent job of making a policy change prediction, so the actual impact on stock is less than the full change in policy. Bernanke’s research measures the equity multiplier, how much does the stock market move for a given unanticipated change in rates. He finds that the impact is between 2.5 and 5. This means that at the extreme for every basis point cut in rates there will be a 5 basis point gain in stock prices. Of course, there will be bigger moves but the overall impact is slight relative to the daily volatility in the market. On average, the Fed just does not have that much effect on equities when there is a change in rates.

The more interesting question is why monetary policy has an impact. On this point, Bernanke states that he found surprising results. The transmission mechanism of monetary policy to stocks is through the change in risk and not through changes in dividend yield and changes in the discount rate. This means that the real impact of monetary policy is its ability to affect risk on the overall economy. It is a change in macro risk which drives equity prices. Consumers will need precautionary savings and business may feel better about the risks for their investments.

He ends his speech with some comments on whether monetary policy should be used to affect stock prices. The answer is a clear no. First, it may be hard to indentify when asset markets would need help. Second, the impact on stocks is small. Third, the transmission mechanism is complex and indirect through the perception of risk to the macro economy. It is unwise to use monetary policy to affect equity prices directly. So what was going through their minds last week?