Stock Prices, Inflation and Monetary Policy
Tatom, John A., Business Economics
Some analysts suggest that the Fed should target equity prices. This article questions this proposal on both theoretical and empirical grounds. There is a negative correlation between the fed funds rate and the price-earnings ratio, but it arises from a significant correlation of each measure with inflation. In the long run, stock prices are independent of the fed funds rate. The real fed funds rate is stationary. Cointegration evidence indicates a negative long-run relationship between stock prices and inflation, in turn implying that higher stock prices are associated with lower inflation and a lower fed funds rate, contrary to recent proposals. Taylor Rule estimates show that the Fed has implicitly acted on this well-founded relationship, exactly the opposite reaction that has been proposed recently. More important, such reactions take into account the correct indicator properties of stock prices, that they anticipate lower inflation, instead of acting as an independent cause of higher inflation.
The link between equity price movements and economic performance, and the implications of this linkage for monetary policy, are the subjects of considerable recent research. In large part, this research has been driven by concern for the sharp increase in U.S. equity prices from 1996 to 2000. This rise was accompanied by increased ownership of equities, both as a share of household assets and as a share of households owning stocks. Thus, it is increasingly important to understand the role that rising equity prices played in the positive performance of the late-1990s and the threat that a large equity price correction could pose in the future.
The focus of recent discussion and research is the wealth effect of stock values on consumer spending. (1) Concern about the wealth effect has led some analysts to propose that the Federal Reserve monitor, or target, stock prices in the conduct of monetary policy. Specifically, in their view, the Fed should raise their fed funds rate target when stock prices are too high relative to a Fed target and lower the fed funds rate target when stock prices are too low. This article does not offer a systematic critique of the wealth effect or take up the issue of how the Fed might find an optimal stock price for the purposes of conducting policy. (2) Instead, it focuses on the relationship of stock prices to inflation and monetary policy to determine if such policy efforts are possible or desirable.
The first section provides an overview of the issues. The article then reviews the relationship between equity prices and the federal funds rate. It argues that the apparent contemporaneous relation between the federal funds rate and stock prices is the result of a spurious correlation. Both factors are related to inflation--stock prices negatively and the fed funds rate positively--hence the inverse correlation of stock prices and the fed funds rate. There is no contemporaneous correlation between the real fed funds rate and equity yields. However, this result is unsettling because real yields should he tied together, allowing for risk premia, whether they are overnight or for infinitely lived assets.
The paper then examines the time series relationship of equity yields, the fed funds rate, and inflation. Two long-run equilibrium relationships are identified that are important for understanding the relationship of stock prices, monetary policy, and inflation. The evidence indicates that there is no long-run relationship between the fed funds rate and stock prices. But it also shows that there is a negative long-run relationship between stock prices and inflation. Thus, higher stock prices reflect success in inflation control rather than posing a threat of higher future inflation. The time series evidence indicates that higher stock prices cause, or systematically lead to, lower inflation and suggests that higher stock prices lead to a lower fed funds rate. …