Measuring the Reaction of Monetary Policy to the Stock Market, Issue 8350
Movements in the stock market can have a significant impact on the macroeconomy and are therefore likely to be an important factor in the determination of monetary policy. However, little is known about the magnitude of the Federal Reserve's reaction to the stock market. One reason is that it is difficult to estimate the policy reaction because of the simultaneous response of equity prices to interest rate changes. This paper uses an identification technique based on the heteroskedasticity of stock market returns to identify the reaction of monetary policy to the stock market. The results indicate that monetary policy reacts significantly to stock market movements, with a 5% rise (fall) in the S&P 500 index increasing the likelihood of a 25 basis point tightening (easing) by about a half. This reaction is roughly of the magnitude that would be expected from estimates of the impact of stock market movements on aggregate demand. Thus, it appears that the Federal Reserve systematically responds to stock price movements only to the extent warranted by their impact on the macroeconomy
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25 basis point aggregate demand Alan Greenspan Asset Prices assumption Brian Sack change in stock common shock correlation covariance matrix daily changes different regimes Economic effect endogeneity estimated policy response expected federal funds rate Federal Reserve Board Gertler heteroskedasticity homoskedastic impact of stock instrumental variables magnitude Mark Gertler Mass below zero Mean of distribution misspecified monetary policy reaction Monetary Policy Rules monetary policy shocks NBER Working Papers output and inflation output gap overidentifying restrictions parameter policy reaction function quadratic equation rank condition rates and stock reaction of monetary reduced form innovations Regimes Regimes Regimes Rudi Dornbusch shift short-term interest rates shown in Figure specification standard deviation stock market movements stock market returns stock market shocks stock market wealth stock price movements stock returns subsets of regimes system of equations Table test of overidentifying three regimes three-month Treasury bill Treasury bill rate unobservable shocks variance-covariance matrix volatility