Long-term monetary policy and asset valuation - Dovish and hawkish regimes

 

Monetary policy shocks may have short-lived effects on real assets, but long-term asset valuation seem to be tied to monetary policy regimes which can last for extended periods. Long-term policy regimes have a strong effect on real interest rates. 

A regime that is dovish by creating a negative real rate versus an equilibrium rate should see increased asset valuations while a hawkish regime where real rates are above equilibrium rates will deflate asset valuations. This concept is simple. The hard work is associated with measuring the regime and matching with asset values. Recent work shows that there can be relatively simple measures for describing the long-term policy regime and linking with investor expectations of policy, see "Monetary Policy and Asset Valuations".

The basic premise for determining the policy regime is through the monetary policy spread (MPS) which is the Fed funds rate - expected inflation - r*, the equilibrium real rate, or simple the real Fed funds rate minus r* which is calculated by the Fed. A negative (positive) MPS is a dovish (hawkish) regime which will be associated with high (low) asset valuations and low (high) equity market return premia. Low real rates (dovish monetary policy) are tied to lower risk premia as investor extrapolate the continuity of policy which is consistent with evidence in the Treasury market. 

The link between MPS and monetary policy is through the conduct of monetary policy and investor beliefs about the infrequent shift in monetary policy rules. Low MPS are associated with dovish monetary policy through higher target inflation and less responsiveness to inflation relative to growth. Sticky inflation expectations will create environments for long-term MPS regimes.