Monetary Policy and Stock Price Returns

Some studies have argued that monetary policy affects stock market performance over monthly or quarterly horizons, which has important implications for both investors and central bankers. Previous findings, however, are not robust to the sensitivity analysis reported here. For example, division of the sample period into subperiods and use of rolling regressions for the time-series data indicate that for the vast majority of countries (including the United States), the relationship largely vanished in more recent periods. Also, panel regressions that incorporate cross-sectional variance among the 16 countries suggest that the relationship between monetary policy and stock returns is weak or nonexistent. Analysis of excess stock price return, as opposed to raw return, also indicates no relationship. Finally, alternative measures of monetary policy indicate no correlation between easing/tightening cycles and stock returns. Stock market participants justifiably watch monetary policy quite closely. Some studies have suggested that changes in central bank policy correlate with stock market performance. Specifically, easing (tightening) cycles are associated with higher (lower) stock prices. Significant results of tests for this relationship imply that profitable trading strategies are feasible and that central bankers can effectively target stock prices. Most researchers have focused on short-run data from the United States; only a few studies have examined long-run performance or cross-country data.This study reexamined the monthly and quarterly data for 16 countries, including the United States, for the 1956–2000 period in four ways. First, previous studies covered a rather lengthy period, but numerous changes during this 45-year span in the targets of monetary policy and in central bank transparency raise the question of whether the relationship still holds. Therefore, I divided the sample period into subperiod time series and also used rolling estimations. The findings suggest that in recent periods, the relationship between stock returns and monetary policy has weakened in most countries (including the United States).Second, the existing literature has not used cross-sectional variance to influence estimations of the relationship, but whether or not this empirical relationship holds across countries at a given point in time is critical for international equity portfolio managers who must make allocation decisions. Therefore, I conducted panel regressions (using data for the same 16 countries) and largely found no consistently significant correlation between monetary policy and stock returns.Third, previous studies used raw stock price return, not excess return, a distinction that has considerable implications for asset allocation decisions. If changes in the domestic risk-free rate solely drive stock price movements, and if monetary policy has no impact on excess return, then the rationale for portfolio managers to shift into (out of) equity markets and out of (into) other asset classes during periods of easing (tightening) monetary policy is less compelling. I indeed found that the results are highly sensitive to whether raw or excess price return was used.Fourth, because the use of the nominal discount rate in studies of the relationship between stock returns and monetary policy is problematic, this study also used an alternative measure of monetary policy, the inflation-adjusted stance, which also indicated a weak relationship between monetary policy and stock market performance.My findings have implications for investors, portfolio managers, and central bankers. The relationship between monetary policy changes and stock performance in earlier periods may have been an anomaly that investors have since arbitraged away. For example, monetary authorities may have more clearly signaled policy changes, or market participants may have more accurately anticipated policy movements over time. For central bankers, the findings imply that using monetary policy to target stock prices is a complicated (in addition to being a highly controversial) objective. This conclusion is somewhat ironic in light of the increased proportion of equity to total household wealth across some parts of the globe. Apart perhaps from monetary policy surprises, which this study did not directly measure, monetary policy transmission mechanisms that work through the stock market have become less potent even as their potential for real effects has increased.