1 Unconventional monetary policy and the stock market’s reaction to Federal Reserve policy actions Abstract: We examine the change in the effect of Federal Reserve’s policy actions on stock returns after the Fed started to use unconventional policy actions. We find that the response of stock returns to monetary policy actions are almost seven times higher after the federal funds rate hit the zero lower bound. We conduct additional analysis to examine the underlying causes of the increase in the impact of monetary policy actions of stock returns. We show that investors rebalance their portfolios towards equity after selling Treasury securities to the Federal Reserve during Large Scale Asset Purchases. JEL Codes: E43; E44; E52; G12 Keywords: Monetary policy; Stock market; Zero lower bound; LSAP
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Unconventional monetary policy and the stock market’s reaction to
Federal Reserve policy actions
Abstract: We examine the change in the effect of Federal Reserve’s policy actions on stock returns after the Fed started to use unconventional policy actions. We find that the response of stock returns to monetary policy actions are almost seven times higher after the federal funds rate hit the zero lower bound. We conduct additional analysis to examine the underlying causes of the increase in the impact of monetary policy actions of stock returns. We show that investors rebalance their portfolios towards equity after selling Treasury securities to the Federal Reserve during Large Scale Asset Purchases.
JEL Codes: E43; E44; E52; G12
Keywords: Monetary policy; Stock market; Zero lower bound; LSAP
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“LSAPs also appear to have boosted stock prices, presumably both by lowering discount rates and by improving the economic outlook; it is probably not a coincidence that the sustained recovery in U.S. equity prices began in March 2009, shortly after the FOMC's decision to greatly expand securities purchases. This effect is potentially important because stock values affect both consumption and investment decisions.” (Ben S. Bernanke, Jackson Hole, Wyoming, August 31, 2012)
1 Introduction
Before the financial crisis of 2007-09, the Federal Reserve (Fed) was using the federal funds
rate as the main policy instrument. The Fed lowered the federal funds rate to boost aggregate
demand and provide economic stimulus. However, since the end of 2008 the Federal Open
Market Committee (FOMC) sets a near-zero target range for the federal funds rate. After hitting
the zero lower bound of the federal funds rate the Fed started to use unconventional monetary
policy tools, namely forward policy guidance1 and large-scale asset purchases (LSAPs), to
support economic recovery. During LSAPs, the Fed purchased longer-term securities with the
goal of putting downward pressure on longer-term interest rates and promote economic activity
by making financial conditions more accommodative. In this paper, we examine the change in
the sensitivity of stock returns to monetary policy actions after the Fed started to use these
unconventional policies.
Many studies in the economics and finance literature examine the relationship between the
stock market and monetary policy. Understanding this relationship is essential for both
monetary policy makers and financial market participants. Bernanke and Kuttner (2005) state
that “The most direct and immediate effects of monetary policy actions, such as changes in the
Federal funds rate, are on the financial markets; … Understanding the links between monetary
policy and asset prices is thus crucially important for understanding the policy transmission
mechanism.” (Page 1221). Monetary policy makers need this information to identify the real
effects of monetary policy actions, and financial market participants require a precise estimate
of the reaction of stock prices to policy actions to design effective investment decisions. Gali and
Gambetti (2014) argue that the recent financial crisis challenged the consensus of the
interaction between monetary policy and financial markets. Accordingly, the investigation of the
structural change in the impact of the actions of the Fed on financial markets has the potential to
provide critical information for both policy makers and investors.
1 In the September 2012 statement, the FOMC states that “the Committee also decided today to keep the target
range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.”
3
The Fed used the unconventional policy actions of forward-guidance and LSAPs after the
federal funds rate reached its zero lower bound. The Fed started to conduct forward-guidance
by making commitments about the future path of the federal funds rate in late 2008. As
summarized in Table 2 of Engen et al (2015), there has been nine FOMC statements which
mention that the exceptionally low levels of the federal funds rate will be warranted in the
future. Starting with the August 2011 statement, the FOMC provided more explicit information
about future policy outlook. Williams (2012) states that forward-guidance was successful in
shifting market expectations about the future path of the federal funds rate. The Fed completed
three LSAPs by purchasing longer-term Treasury and mortgage-backed securities. When the
recent LSAP program ended in October 2014, the Fed’s balance rose from $500 billion to over $4
trillion.
One of the major challenges of this empirical analysis is measurement of the overall stance
of monetary policy. Studies such as Bernanke and Kuttner (2005), Bjorland and Leitemo (2009)
and Gali and Gambetti (2014) use the federal funds rate as a measure of monetary policy when
examining the effect of monetary policy shocks on stock returns.2 On the other hand, since the
federal funds rate was set to the zero lower bound, implementation of unconventional monetary
policy makes it difficult to assess the stance of monetary policy. One possible proxy for this
stance can be the size of the Fed’s balance sheet. Using this proxy, several financial services
companies like the Raymond James Financial3 drew attention to the correlation between S&P
500 index and the total assets of the Fed to examine the relationship between large-scale asset
purchases and stock prices. Figure 1 below displays the expansion of the Fed’s Balance Sheet
though LSAPs and the S&P 500 index.
2 Bernanke and Kuttner (2005) study differs from the other studies mentioned above in a way that use an event-
study approach, based on daily changes observed on monetary policy decision dates, to uncover the response
of stock prices to unanticipated changes in the federal funds rate 3 Technical Strategy Team - Technical Chart Book, May 26 2015.
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Figure 1: Total Assets of the Federal Reserve and the S&P 500 Index
Figure 1 shows that S&P 500 index climbed to 2000 in 2015 from less than 700 in 2009.
Moreover, the figure presents that there is almost one-to-one relationship between the stock
market and expansion of FED’s balance sheet through LSAPs. Figure 1 calls for further analysis
of this relationship between stock returns and unconventional policy actions of FED.
Using the Fed’s balance sheet as a proxy for monetary policy is not problem-free. First of all,
as stated by Wright (2012): “with forward-looking financial markets, one would expect a policy
of asset purchases to impact asset prices not at the time that the purchases are actually made but
rather at the time that investors learn that they will take place.” (Page 448) Since LSAPs are
announced ahead of time, investors form expectations about them and act accordingly. In
addition, the Fed uses other unconventional monetary policy actions like forward guidance to
guide the expectations of the public. Secondly, we need a measure for Fed’s unconventional
monetary policy actions that is consistent with the federal funds rate to be able to assess
whether there is a structural change in the reaction of stock returns to policy shocks. We try to
overcome both problems by using ‘the shadow interest rate’ constructed by Wu and Xia (2015).
This rate is equal to the federal funds rate before 2009, and provide a similar composite measure
for the monetary policy for the following era. Wu and Xia (2015) construct a term structure
Correlation: 0.98 after LSAP
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01
00
01
50
02
00
0
S&
P 5
00
10
00
20
00
30
00
40
00
50
00
To
tal A
sse
ts o
f th
e F
ed
(b
illi
on
$)
2005m1 2010m1 2015m1daten
Fed Total Assets S&P 500
The Fed's Balance Sheet and the S&P 500
5
model which produces a “shadow rate” interacting with macroeconomic variables similarly as
the federal funds rate.4 The shadow rate is derived using a linear function of latent variables
which follow VAR (1) processes. The latent factors and the shadow rate are estimated using one-
month forward rates.
Several methodological issues also present challenges in estimating the reaction of stock
returns to monetary policy. First issue is the endogeneity problem caused by the endogeneity of
monetary policy actions and stock returns. Second, other variables about the macroeconomic
condition of the economy and related news contemporaneously effect monetary policy and stock
returns. Hence, identification of the “responsiveness of asset prices” is problematic under
previously used methods as stated by Rigobon and Sack (2004). In this paper, we follow the
suggestion of Rigobon and Sack (2004) and implement a methodology which “identifies the
response of asset prices based on the heteroskedasticity of monetary policy shocks.” (Page
1554). Our methodology follows Lewbel (2012), which serves to identify structural parameters
in regression models with endogenous or mismeasured regressors.
Our results indicate that the impact of monetary policy on stock returns increases
immensely- almost seven times higher-since the start of the unconventional policy actions at the
end of 2008. To uncover the reasons behind this dramatic change, we examine the effect of
LSAPs on investor portfolios. We find that during LSAPs investors sell Treasury securities to the
Fed and rebalance their portfolios towards riskier assets by buying stocks. This result suggests
that the Fed contributed significantly to the surging stock markets through this portfolio
rebalancing effect. Hence, in line with the claim of Bernanke (2012), our results suggest that it is
really not a coincidence that the substantial rise in U.S. equity prices began after the FOMC's
decision to greatly expand securities purchases.
These results add to the literature which study the economic effects of LSAPs. Gagnon
(2001) show that LSAP announcements decreased U.S. long-term yields using an event study
approach. Hamilton and Wu (2012) develop an affine term structure model to assess the effect
of LSAP on the maturity structure of U.S. debt. Their results suggest that LSAPs were effective at
lowering long-term yields at the zero lower bound. On the contrary, Stroebel and Taylor (2012)
4 Lombardi and Zhu (2014) and Krippner (2012) calculate alternative shadow policy rates than Wu and Xia
(2015)’s for the US economy. We prefer to use the Wu and Xia (2015) shadow rate calculations as presented
by the Federal Reserve Bank of Atlanta for two reasons. First, the Wu and Xia (2015) shadow rate is much
smoother compared to its alternatives. Lombardi and Zhu (2014) rate has very high variation. It switches
between negative and positive values over time. Second, the Wu and Xia (2015) shadow rate does not have
extreme values. For example, Krippner (2012) rate drops to below -9% in August 2011 showing an extremely
Table 2 displays the estimation results of regression equation (5). We are interested in the
coefficient of the change in the Federal Reserve’s holdings of Treasury securities, 𝛽1. 𝛽1
measures the effect of LSAP on the portfolio holdings of the households.
11 The household sector is described as the following in the Flow of Funds: ‘‘the values for the household
sector are calculated as residuals. That is, amounts held or owed by the other sectors are subtracted from known totals, and the remainders are assumed to be the amounts held or owed by the household sector....because of the residual nature of the household sector, assets of entities for which there is no data source, such as domestic hedge funds, private equity funds, and personal trusts, are included in this sector.’’ Available at http://www.federalreserve.gov/apps/fof/DisplayTable.aspx?t=l.100
12 The data period in Carpenter et al. (2015) is 1991:Q1-2012Q3.
Regression Line of S&P 500 and Household Equity Holdings
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rate. Hence, the policy makers should take into account a stronger transmission mechanism
when using LSAPs. These results also provide valuable information for the investors which they
can use while making portfolio decisions.
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