NCPA - Daily Policy Digest - Monetary Policy and the Stock Market

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Monetary Policy and the Stock Market

Now that the Federal Reserve has stopped lowering interest rates, when with they rise again? Since one of the precursors to the recent U.S. recession was a fall in stock market prices, might the stock market give a clue as to future tightening?

Shifts in the stock market clearly influence the direction of the macroeconomy. Does the Federal Reserve react to stock market movements in setting monetary policy?

Determining monetary policy responses to the stock market is difficult, since the stock market reacts to changes in monetary policy even as that policy responds to shifts in the stock market. However, economists Roberto Rigobon and Brian Sack were able to establish a relationship between monetary policy and stock price movements using a mathematical model that allowed them to identify and differentiate between Fed responses to monetary shocks and unexpected stock market movements:

Specifically, they found that an unexpected 5 percent increase in the Standard & Poor's 500 index hikes by just over half the probability of a 25 basis point tightening at the next Federal Open Market Committee Meeting.

The same calculation works for a monetary easing -- in other words, if the probability of a monetary easing were 30 percent under existing economic conditions, an unexpected 5 percent decline in stock prices would increase the probability of a cut in the Fed's benchmark short-term interest rate to 80 percent.

This does not mean, the economists emphasize, that the Fed targets stock prices. Alan Greenspan has said central banks should focus on achieving price stability and maximum sustainable growth, and that policymakers should respond to stock prices according to their influence on projected output and inflation. The findings are consistent with that strategy.

Source: Chris Farrell, "How the Fed Responds to Stock Market Moves," NBER Digest, September 2001; based on Roberto Rigobon and Brian Sack, "Measuring The Reaction of Monetary Policy to the Stock Market," NBER Working Paper No. 8350, July 2001, National Bureau of Economic Research.

For NBER Digest text
http://www.nber.org/digest/sep01/w8350.html

For Fed monetary policy
http://www.ncpa.org/iss/eco/

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