Academic journal article Economic Inquiry

Monetary Policy and the U.S. Stock Market

Academic journal article Economic Inquiry

Monetary Policy and the U.S. Stock Market

Article excerpt

I. INTRODUCTION

The monetary policy goals of the Federal Reserve System, as often stated in publications and testimony of Fed officials, are "price stability" and "sustainable economic growth." Recently, Fed officials and academic economists have addressed the question of whether in addition to price level stability, a central bank should also consider the stability of assets prices. As Federal Reserve Chairman Alan Greenspan (1996) asked,

   where do we draw the line on what prices matter?
   Certainly prices of goods and services now being
   produced--our basic measure of inflation--matter.
   But what about futures prices or more importantly
   prices of claims on future goods and
   services, like equities, real estate, or other earning
   assets? Is stability of these prices essential to the
   stability of the economy?

Greenspan (1996) answered his own question in the form of both reflections and additional questions: "But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy?"

In response to these statements, the academic literature has addressed both the normative question "should monetary policy react to asset bubbles?" as well as the positive question "does monetary policy react to asset bubbles?" After a review of the academic literature in section II, this article focuses on the positive question of whether monetary policy since 1987 has been influenced by the high valuation of the stock market. As mentioned earlier, Greenspan (1996) indicated he believed that soaring stock prices might create imbalances that would threaten the goals of general price level stability and sustainable economic growth. Such warnings, however, were followed by speeches by Greenspan (1998, 1999a, 1999b, 2002b), in which due to the high rates of productivity of the "new economy," Greenspan hinted that share prices might not be overvalued after all. Beyond issues of a "new economy" and high levels of productivity due to information technologies, Greenspan (2002a) also reflected that lower risk premiums might rationalize higher stock market valuations than in the past. Greenspan's views about share prices clearly evolved over time and show his intellectual interest in the implications of stock market valuations for monetary policy. It is natural to ask: Did the chairman's concerns about the stock market actually influence monetary policy decisions? Put differently, considering the two competing assessments made by the chairman of irrational exuberance (and its logical implication that stock market prices were unsustainably high) or the new economy (justifying high share prices because of high productivity gains and low inflation), it is important to clarify which view ultimately guided monetary policy.

It is the purpose of this article to present empirical evidence that indicates that the new economy rhetoric won out over concerns about irrational exuberance. In section III we use the price/earnings ratio as a signal of potential overvaluation, and in section IV we give a brief overview of the evidence from the FOMC minutes to ground our empirical analysis on the Fed's deliberations. In section V, we present and estimate a forward-looking Taylor rule model using revised and real-time data. In section VI we revisit the question of Fed policy in response to stock market overvaluation using the vector autoregressive (VAR) methodology. The last section summarizes our conclusions.

II. NORMATIVE VERSUS POSITIVE ISSUES

How should monetary policy react to a stock market bubble? Using the language of control theory, we can ask the more technical question: Should monetary policy target the level of equity prices, measured by an index such as the Standard & Poor (S&P) 500 Index? …

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