Stock Returns and Monetary Policy: Are There Any Ties? Hafedh Bouakez, Badye-Omar Essid, and Michel Normandin December 2010 Abstract This paper empirically investigates the following three questions: (i) Do stock returns respond to monetary policy shocks? (ii) Do stock returns alter the transmission mechanism of monetary policy? and (iii) Does monetary policy systematically react to stock returns? Existing research based on event studies and Structural Vector Auto-Regressions (SVAR) documents that stock returns increase significantly following an unanticipated monetary policy expansion. However, this literature did not explore whether or not stock returns matter for the choice of monetary policy or its propagation mechanism. In this paper, we use a SVAR that relaxes the restrictions commonly imposed in earlier studies and identify monetary policy shocks by exploiting the conditional heteroscedasticity of the structural innovations. Applying this method to U.S. data, we reach a surprising and puzzling conclusion: the answers to the three questions above are No, No, and No! JEL Classification: C32, E44, E52, G12 Keywords: Conditional Heteroscedasticity, Identification, Monetary Policy, Stock Return, Structural Vector Autoregression. Bouakez: Department of Economics, HEC Montr´ eal and CIRP ´ EE, 3000 Chemin de la Cˆ ote-Sainte-Catherine, Montr´ eal, Qu´ ebec, Canada, H3T 2A7. E-mail address: [email protected]. Essid: Department of Economics, HEC Montr´ eal and CIRP ´ EE, 3000 Chemin de la Cˆ ote-Sainte-Catherine, Montr´ eal, Qu´ ebec, Canada, H3T 2A7. E-mail address: [email protected]. * Corresponding Author. Normandin: Department of Economics, HEC Montr´ eal, CIRP ´ EE, 3000 Chemin de la Cˆ ote-Sainte-Catherine, Montr´ eal, Qu´ ebec, Canada, H3T 2A7. E-mail address: [email protected]. Phone number: (514) 340-6841. Fax number: (514) 340-6469.
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Stock Returns and Monetary Policy: Are There Any Ties?Normandin: Department of Economics, HEC Montr´eal, CIRPEE, 3000 Chemin de la Cˆote-Sainte-Catherine, Montr´eal, Qu´´ ebec,
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Stock Returns and Monetary Policy: Are There Any Ties?
Hafedh Bouakez, Badye-Omar Essid, and Michel Normandin
December 2010
Abstract
This paper empirically investigates the following three questions: (i) Do stock returnsrespond to monetary policy shocks? (ii) Do stock returns alter the transmission mechanismof monetary policy? and (iii) Does monetary policy systematically react to stock returns?Existing research based on event studies and Structural Vector Auto-Regressions (SVAR)documents that stock returns increase significantly following an unanticipated monetarypolicy expansion. However, this literature did not explore whether or not stock returnsmatter for the choice of monetary policy or its propagation mechanism. In this paper,we use a SVAR that relaxes the restrictions commonly imposed in earlier studies andidentify monetary policy shocks by exploiting the conditional heteroscedasticity of thestructural innovations. Applying this method to U.S. data, we reach a surprising andpuzzling conclusion: the answers to the three questions above are No, No, and No!
Bouakez: Department of Economics, HEC Montreal and CIRPEE, 3000 Cheminde la Cote-Sainte-Catherine, Montreal, Quebec, Canada, H3T 2A7. E-mail address:[email protected].
Essid: Department of Economics, HEC Montreal and CIRPEE, 3000 Cheminde la Cote-Sainte-Catherine, Montreal, Quebec, Canada, H3T 2A7. E-mail address:[email protected].
∗ Corresponding Author. Normandin: Department of Economics, HEC Montreal,CIRPEE, 3000 Chemin de la Cote-Sainte-Catherine, Montreal, Quebec,Canada, H3T 2A7. E-mail address: [email protected]. Phone number: (514)340-6841. Fax number: (514) 340-6469.
1. Introduction
This paper empirically investigates the following three questions using monthly U.S. data:
(i) Do stock returns respond to monetary policy shocks? ii) Do stock returns alter the
transmission mechanism of monetary policy? and (iii) Does monetary policy systematically
react to stock returns? We reach a surprising and puzzling conclusion: the answers to the
three questions above are No, No, and No!
The interdependence between asset prices and monetary policy is a central issue in financial
economics, in which interest has been rekindled in light of the latest global financial crisis.
Yet, among the various aspects of this interdependence, only the responsiveness of stock
returns to monetary policy shocks has received significant attention in the empirical litera-
ture. In contrast, the questions of whether stock returns matter for the choice of monetary
policy or whether they affect its propagation mechanism have remained largely unexplored
from an empirical standpoint, despite being highly controversial among academics and
policy-makers.
Earlier research that focused on measuring the responsiveness of stock returns to monetary
policy shocks can be grouped into two strands: event studies, which rely on a narrative
approach to isolate exogenous and unanticipated changes in monetary policy, and those
based on estimating Structural Vector Auto-Regressions (SVAR). By and large, this liter-
ature finds that stock returns increase significantly following an unanticipated monetary
policy expansion. Both approaches, however, need to impose strong and sometimes dubi-
ous identifying assumptions, which, as we show in this paper, are not innocuous. Event
studies implicitly assume that monetary policy shocks swamp any other structural shocks
during periods where a decision about monetary policy is to be taken (e.g. Cook and
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35
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37
Table 1. Estimates: GARCH(1,1) Parameters
ε1,t — εd,t 0.537(0.166)
— 0.388(0.125)
ε2,t 0.161 εb,t 0.433(0.046) (0.160)0.783 —
(0.080)
ε3,t 0.200 ε7,t 0.062(0.090) (0.029)0.281 0.935
(0.328) (0.032)
εs,t 0.234 ε8,t 0.077(0.049) (0.058)0.763 0.889
(0.048) (0.084)
Note: Entries are the estimates of the parameters of the GARCH(1,1) processes for theflexible system. For each structural innovation, the first and second rows refer to the ARCHand GARCH coefficients, respectively. Numbers in parentheses are standard errors. —indicates that zero restrictions are imposed to ensure that ∆1 and ∆2 are non-negativedefinite.
38
Table 2. Estimates: Reserve-Market Parameters
α 0.062 σs 0.025(0.079) (0.017)
β 5.089 σd 0.022(2.847) (0.013)
φd 0.922 σb 0.073(0.028) (0.044)
φb 0.014(0.017)
Note: Entries are the estimates of the structural parameters of the reserve market for theflexible system. Numbers in parentheses are standard errors.
Note: Entries are the impact responses of the news in excess returns and of the revisionsin expectations of the various components. Number in parentheses are standard errors.
41
Table 5. Estimates: Feedback-Rule Parameters
Simultaneous Recursive
Variables Flexible S R1 R2
srt -0.0001 0.0009 — —(0.0001) (0.0003)
et = (srt − tbrt) 0.0262 0.0009 — —(0.0176) (0.0003)
Note: Entries are the estimates of the coefficients of the monetary authority’s feedbackrule. Numbers in parentheses are standard errors.
42
Figure 1. Monetary Policy Shocks
Simultaneous: Flexible
1983 1986 1989 1992 1995 1998 2001 2004 2007-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
Recursive: R1
1983 1986 1989 1992 1995 1998 2001 2004 2007-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
Simultaneous: S
1983 1986 1989 1992 1995 1998 2001 2004 2007-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
Recursive: R2
1983 1986 1989 1992 1995 1998 2001 2004 2007-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
Note: The solid lines correspond to monetary policy shocks recovered from the flexiblesystem. The dotted lines are monetary policy shocks obtained from the alternative systems.The shaded areas represent contractionary phases (i.e. peaks to troughs) reported by theNational Bureau of Economic Research (NBER).
43
Figure 2. Responses: Selected Variables
Simultaneous: Flexible
y
5 10 15 20-0.0025
0.0000
0.0025
0.0050
0.0075
0.0100
p
5 10 15 20-0.003
-0.002
-0.001
0.000
0.001
0.002
0.003
cp
5 10 15 20-0.02
-0.01
0.00
0.01
0.02
0.03
nb
r
5 10 15 20-0.02
0.00
0.02
0.04
0.06
0.08
tr
5 10 15 20-0.015
-0.010
-0.005
0.000
0.005
0.010
0.015
0.020
ffr
5 10 15 20-0.04
-0.03
-0.02
-0.01
0.00
0.01
0.02
0.03
0.04
tbr
5 10 15 20-0.050
-0.025
0.000
0.025
0.050
Simultaneous: S
y
5 10 15 20-0.0025
0.0000
0.0025
0.0050
0.0075
0.0100
p
5 10 15 20-0.003
-0.002
-0.001
0.000
0.001
0.002
0.003cp
5 10 15 20-0.02
-0.01
0.00
0.01
0.02
0.03
nb
r
5 10 15 20-0.02
0.00
0.02
0.04
0.06
0.08
tr
5 10 15 20-0.015
-0.010
-0.005
0.000
0.005
0.010
0.015
0.020
ffr
5 10 15 20-0.04
-0.03
-0.02
-0.01
0.00
0.01
0.02
0.03
0.04
tbr
5 10 15 20-0.050
-0.025
0.000
0.025
0.050
Recursive: R1
y
5 10 15 20-0.0025
0.0000
0.0025
0.0050
0.0075
0.0100
p
5 10 15 20-0.003
-0.002
-0.001
0.000
0.001
0.002
0.003
cp
5 10 15 20-0.02
-0.01
0.00
0.01
0.02
0.03
nb
r
5 10 15 20-0.02
0.00
0.02
0.04
0.06
0.08
tr
5 10 15 20-0.015
-0.010
-0.005
0.000
0.005
0.010
0.015
0.020
ffr
5 10 15 20-0.04
-0.03
-0.02
-0.01
0.00
0.01
0.02
0.03
0.04
tbr
5 10 15 20-0.050
-0.025
0.000
0.025
0.050
Recursive: R2
y
5 10 15 20-0.0025
0.0000
0.0025
0.0050
0.0075
0.0100
p
5 10 15 20-0.003
-0.002
-0.001
0.000
0.001
0.002
0.003
cp
5 10 15 20-0.02
-0.01
0.00
0.01
0.02
0.03
nb
r5 10 15 20
-0.02
0.00
0.02
0.04
0.06
0.08
tr
5 10 15 20-0.015
-0.010
-0.005
0.000
0.005
0.010
0.015
0.020
ffr
5 10 15 20-0.04
-0.03
-0.02
-0.01
0.00
0.01
0.02
0.03
0.04
tbr
5 10 15 20-0.050
-0.025
0.000
0.025
0.050
Note: The solid lines correspond to the dynamic responses of selected variables to anexpansionary monetary policy shock extracted from the various systems. The dotted linesare the 68% confidence intervals computed from the Sims-Zha (1999) Bayesian procedure.
44
Figure 3. Responses: Stock Returns
Simultaneous: Flexible
sr
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
h=sr
-pi
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
e=sr
-tbr
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
Simultaneous: S
sr-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
h=sr
-pi
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
e=sr
-tbr
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
Recursive: R1
sr
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
h=sr
-pi
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
e=sr
-tbr
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
Recursive: R2
sr
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
h=sr
-pi
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
e=sr
-tbr
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
Note: The solid lines correspond to the dynamic responses of stock returns to an expan-sionary monetary policy shock extracted from the various systems. The dotted lines arethe 68% confidence intervals computed from the Sims-Zha (1999) Bayesian procedure.
45
Figure 4. Responses: Stock Returns for Industry Portfolios
Fama and French
No
nd
ura
ble
s
2 4 6 8 10 12 14 16 18 20 22 24
-2.7
-1.8
-0.9
-0.0
0.9
1.8
2.7
Dura
ble
s
5 10 15 20-2.7
-1.8
-0.9
-0.0
0.9
1.8
2.7
Manuf
5 10 15 20-2.7
-1.8
-0.9
-0.0
0.9
1.8
2.7
Energ
y
5 10 15 20-2.7
-1.8
-0.9
-0.0
0.9
1.8
2.7
Hig
h-T
ech
5 10 15 20-2.7
-1.8
-0.9
-0.0
0.9
1.8
2.7
Fama and French
Te
leco
m
2 4 6 8 10 12 14 16 18 20 22 24
-2.7
-1.8
-0.9
-0.0
0.9
1.8
2.7
Sale
s
5 10 15 20-2.7
-1.8
-0.9
-0.0
0.9
1.8
2.7
Health C
are
5 10 15 20-2.7
-1.8
-0.9
-0.0
0.9
1.8
2.7
Utilities
5 10 15 20-2.7
-1.8
-0.9
-0.0
0.9
1.8
2.7
Oth
ers
5 10 15 20-2.7
-1.8
-0.9
-0.0
0.9
1.8
2.7
Gomes, Kogan, and Yogo
Se
rvic
es
2 4 6 8 10 12 14 16 18 20 22 24
-2.7
-1.8
-0.9
-0.0
0.9
1.8
2.7
Nondura
ble
s
5 10 15 20-2.7
-1.8
-0.9
-0.0
0.9
1.8
2.7
Dura
ble
s5 10 15 20
-2.7
-1.8
-0.9
-0.0
0.9
1.8
2.7
Investm
ent
5 10 15 20-2.7
-1.8
-0.9
-0.0
0.9
1.8
2.7
Oth
ers
5 10 15 20-2.7
-1.8
-0.9
-0.0
0.9
1.8
2.7
Note: The solid lines correspond to the dynamic responses of stock returns to an expan-sionary monetary policy shock extracted from the flexible system. The dotted lines arethe 68% confidence intervals computed from the Sims-Zha (1999) Bayesian procedure.
46
Figure 5. Responses: Stock Returns for Size and Growth Portfolios
Size
S1
5 10 15 20-4
-3
-2
-1
0
1
2
3
4
S2
5 10 15 20-4
-3
-2
-1
0
1
2
3
4
S3
5 10 15 20-4
-3
-2
-1
0
1
2
3
4
S4
5 10 15 20-4
-3
-2
-1
0
1
2
3
4
S5
5 10 15 20-4
-3
-2
-1
0
1
2
3
4
Growth
G1
5 10 15 20-4
-3
-2
-1
0
1
2
3
4
G2
5 10 15 20-4
-3
-2
-1
0
1
2
3
4
G3
5 10 15 20-4
-3
-2
-1
0
1
2
3
4
G4
5 10 15 20-4
-3
-2
-1
0
1
2
3
4
G5
5 10 15 20-4
-3
-2
-1
0
1
2
3
4
Size and Growth
S1-G
1
5 10 15 20-4
-3
-2
-1
0
1
2
3
4
S1-G
5
5 10 15 20-4
-3
-2
-1
0
1
2
3
4
S3-G
35 10 15 20
-4
-3
-2
-1
0
1
2
3
4
S5-G
1
5 10 15 20-4
-3
-2
-1
0
1
2
3
4
S5-G
5
5 10 15 20-4
-3
-2
-1
0
1
2
3
4
Note: The solid lines correspond to the dynamic responses of stock returns to an expan-sionary monetary policy shock extracted from the flexible system. The dotted lines arethe 68% confidence intervals computed from the Sims-Zha (1999) Bayesian procedure.
47
Figure 6. Responses: Price Level, Output,and Components of Aggregate Expenditures
Simultaneous: Flexible
p
5 10 15 20-0.0020
-0.0015
-0.0010
-0.0005
0.0000
0.0005
0.0010
0.0015
y
5 10 15 20
-0.002
-0.001
0.000
0.001
0.002
0.003
0.004
0.005
0.006
0.007
Du
rab
les
5 10 15 20
-0.0050
-0.0025
0.0000
0.0025
0.0050
No
nd
ur+
Se
rvic
es
5 10 15 20
-0.0050
-0.0025
0.0000
0.0025
0.0050
Inve
stm
en
t
5 10 15 20
-0.0050
-0.0025
0.0000
0.0025
0.0050
Simultaneous: S
p
5 10 15 20-0.0020
-0.0015
-0.0010
-0.0005
0.0000
0.0005
0.0010
0.0015
y
5 10 15 20
-0.002
-0.001
0.000
0.001
0.002
0.003
0.004
0.005
0.006
0.007
Du
rab
les
5 10 15 20
-0.0050
-0.0025
0.0000
0.0025
0.0050
No
nd
ur+
Se
rvic
es
5 10 15 20
-0.0050
-0.0025
0.0000
0.0025
0.0050
Inve
stm
en
t
5 10 15 20
-0.0050
-0.0025
0.0000
0.0025
0.0050
Recursive: R1
p
5 10 15 20-0.0020
-0.0015
-0.0010
-0.0005
0.0000
0.0005
0.0010
0.0015
y
5 10 15 20
-0.002
-0.001
0.000
0.001
0.002
0.003
0.004
0.005
0.006
0.007
Du
rab
les
5 10 15 20
-0.0050
-0.0025
0.0000
0.0025
0.0050
No
nd
ur+
Se
rvic
es
5 10 15 20
-0.0050
-0.0025
0.0000
0.0025
0.0050
Inve
stm
en
t
5 10 15 20
-0.0050
-0.0025
0.0000
0.0025
0.0050
Recursive: R2
p
5 10 15 20-0.0020
-0.0015
-0.0010
-0.0005
0.0000
0.0005
0.0010
0.0015
y
5 10 15 20
-0.002
-0.001
0.000
0.001
0.002
0.003
0.004
0.005
0.006
0.007
Du
rab
les
5 10 15 20
-0.0050
-0.0025
0.0000
0.0025
0.0050
No
nd
ur+
Se
rvic
es
5 10 15 20
-0.0050
-0.0025
0.0000
0.0025
0.0050
Inve
stm
en
t
5 10 15 20
-0.0050
-0.0025
0.0000
0.0025
0.0050
Note: The solid lines correspond to the dynamic responses of selected variables to anexpansionary monetary policy shock extracted from the various systems. The dotted linesrepresent the dynamic responses of selected variables to an expansionary monetary policyshock obtained by imposing certain restrictions on each system which imply that theresponse of nominal stock returns is nil.
48
Figure 7. Responses: Monetary Policy Indicators
Simultaneous: Flexible
ffr
5 10 15 20-0.025
-0.020
-0.015
-0.010
-0.005
0.000
0.005
0.010
0.015
0.020
tr
5 10 15 20-0.0100
-0.0075
-0.0050
-0.0025
0.0000
0.0025
0.0050
0.0075
0.0100
nbr
5 10 15 20-0.01
0.00
0.01
0.02
0.03
0.04
Simultaneous: S
ffr
5 10 15 20-0.025
-0.020
-0.015
-0.010
-0.005
0.000
0.005
0.010
0.015
0.020
Recursive: R1
ffr
5 10 15 20-0.025
-0.020
-0.015
-0.010
-0.005
0.000
0.005
0.010
0.015
0.020
Recursive: R2
ffr
5 10 15 20-0.025
-0.020
-0.015
-0.010
-0.005
0.000
0.005
0.010
0.015
0.020
Note: The solid lines correspond to the dynamic responses of the reserve variables to anexpansionary monetary policy shock extracted from the various systems. The dotted linesrepresent the dynamic responses of the reserve variables to an expansionary monetarypolicy shock obtained by imposing certain restrictions on each system which imply thatthe response of nominal stock returns is nil.
49
Figure 8. Responses: Reserve Variables
NBR
ep
silo
n_
1
2 4 6 8 10 12 14 16 18 20 22 24
-0.036
-0.024
-0.012
-0.000
0.012
0.024
0.036
epsilon_2
2 4 6 8 10 12 14 16 18 20 22 24-0.036
-0.024
-0.012
-0.000
0.012
0.024
0.036
epsilon_3
2 4 6 8 10 12 14 16 18 20 22 24
-0.036
-0.024
-0.012
-0.000
0.012
0.024
0.036
epsilon_s
2 4 6 8 10 12 14 16 18 20 22 24-0.04
-0.03
-0.02
-0.01
0.00
0.01
0.02
0.03
0.04
epsilon_d
2 4 6 8 10 12 14 16 18 20 22 24-0.036
-0.024
-0.012
-0.000
0.012
0.024
0.036
epsilon_b
2 4 6 8 10 12 14 16 18 20 22 24-0.036
-0.024
-0.012
-0.000
0.012
0.024
0.036
epsilon_7
2 4 6 8 10 12 14 16 18 20 22 24-0.036
-0.024
-0.012
-0.000
0.012
0.024
0.036
epsilon_8
2 4 6 8 10 12 14 16 18 20 22 24-0.036
-0.024
-0.012
-0.000
0.012
0.024
0.036
FFR
ep
silon
_1
2 4 6 8 10 12 14 16 18 20 22 24
-0.036
-0.024
-0.012
-0.000
0.012
0.024
0.036
epsilon_2
2 4 6 8 10 12 14 16 18 20 22 24-0.036
-0.024
-0.012
-0.000
0.012
0.024
0.036
epsilon_3
2 4 6 8 10 12 14 16 18 20 22 24
-0.036
-0.024
-0.012
-0.000
0.012
0.024
0.036epsilon_s
2 4 6 8 10 12 14 16 18 20 22 24-0.04
-0.03
-0.02
-0.01
0.00
0.01
0.02
0.03
0.04
epsilon_d
2 4 6 8 10 12 14 16 18 20 22 24-0.036
-0.024
-0.012
-0.000
0.012
0.024
0.036
epsilon_b
2 4 6 8 10 12 14 16 18 20 22 24-0.036
-0.024
-0.012
-0.000
0.012
0.024
0.036
epsilon_7
2 4 6 8 10 12 14 16 18 20 22 24-0.036
-0.024
-0.012
-0.000
0.012
0.024
0.036
epsilon_8
2 4 6 8 10 12 14 16 18 20 22 24-0.036
-0.024
-0.012
-0.000
0.012
0.024
0.036
TR
ep
silon
_1
2 4 6 8 10 12 14 16 18 20 22 24
-0.036
-0.024
-0.012
-0.000
0.012
0.024
0.036
epsilon_2
2 4 6 8 10 12 14 16 18 20 22 24-0.036
-0.024
-0.012
-0.000
0.012
0.024
0.036
epsilon_3
2 4 6 8 10 12 14 16 18 20 22 24
-0.036
-0.024
-0.012
-0.000
0.012
0.024
0.036
epsilon_s
2 4 6 8 10 12 14 16 18 20 22 24-0.04
-0.03
-0.02
-0.01
0.00
0.01
0.02
0.03
0.04
epsilon_d
2 4 6 8 10 12 14 16 18 20 22 24-0.036
-0.024
-0.012
-0.000
0.012
0.024
0.036
epsilon_b
2 4 6 8 10 12 14 16 18 20 22 24-0.036
-0.024
-0.012
-0.000
0.012
0.024
0.036
epsilon_7
2 4 6 8 10 12 14 16 18 20 22 24-0.036
-0.024
-0.012
-0.000
0.012
0.024
0.036
epsilon_8
2 4 6 8 10 12 14 16 18 20 22 24-0.036
-0.024
-0.012
-0.000
0.012
0.024
0.036
Note: The solid lines correspond to the dynamic responses of the reserve variables to anexpansionary monetary policy shock extracted from the flexible systems. The dotted linesrepresent the dynamic responses of the reserve variables to an expansionary monetarypolicy shock obtained by imposing certain restrictions on the flexible system which implythat the response of nominal stock returns is nil.