Stock Prices, Inflation and Monetary Policy

By Tatom, John A. | Business Economics, October 2002 | Go to article overview

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. …

The rest of this article is only available to active members of Questia

Sign up now for a free, 1-day trial and receive full access to:

  • Questia's entire collection
  • Automatic bibliography creation
  • More helpful research tools like notes, citations, and highlights
  • Ad-free environment

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Default project is now your active project.
Project items

Items saved from this article

This article has been saved
Highlights (0)
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

Citations (0)
Some of your citations are legacy items.

Any citation created before July 30, 2012 will labeled as a “Cited page.” New citations will be saved as cited passages, pages or articles.

We also added the ability to view new citations from your projects or the book or article where you created them.

Notes (0)
Bookmarks (0)

You have no saved items from this article

Project items include:
  • Saved book/article
  • Highlights
  • Quotes/citations
  • Notes
  • Bookmarks
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited article

Stock Prices, Inflation and Monetary Policy
Settings

Settings

Typeface
Text size Smaller Larger Reset View mode
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

Full screen

matching results for page

Cited passage

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited passage

Thanks for trying Questia!

Please continue trying out our research tools, but please note, full functionality is available only to our active members.

Your work will be lost once you leave this Web page.

For full access in an ad-free environment, sign up now for a FREE, 1-day trial.

Already a member? Log in now.