Academic journal article Journal of Money, Credit & Banking

Taking Stock: Monetary Policy Transmission to Equity Markets

Academic journal article Journal of Money, Credit & Banking

Taking Stock: Monetary Policy Transmission to Equity Markets

Article excerpt

ONE CENTRAL ARGUMENT of James Tobin's seminal 1969 Journal of Money, Credit and Banking paper was that "financial policies" can play a crucial role in altering what later became known as Tobin's q, the market value of a firm's assets relative to their replacement costs. Tobin emphasized that, in particular, monetary policy can change this ratio. This 1969 JMCB paper together with another of his contributions (Tobin 1978) became a key element in the formulation and understanding of the stock market channel of monetary policy transmission. Tobin's argument in this work was that a tightening of monetary policy, which may result from an increase in inflation, lowers the present value of future earning flows and hence depresses equity markets.

The second part of Tobin's argument, namely the relationship between monetary policy and equity prices, is still not very well understood. On the one hand, it has proven difficult to properly identify monetary policy, since monetary policy may be endogenous in that central banks might react to developments in stock markets. Considerable progress has recently been made in this respect. Rigobon and Sack (2002, 2003) develop a methodology that exploits the heteroskedasticity present in financial markets to identify monetary policy shocks, while Kuttner (2001) and Bernanke and Kuttner (2003) derive monetary policy shocks through measures of market expectations obtained from federal funds futures contracts. In this paper, we will employ a methodology similar to Bernanke and Kuttner (2003), by identifying monetary policy shocks through market expectations obtained from surveys of market participants.

On the other hand, more research is needed to understand why individual stocks react so differently to monetary policy shocks and what the driving force is behind this reaction. The recent paper by Bernanke and Kuttner (2003) shows that very little of the market's reaction can be attributed to the effect of monetary policy on the real rate of interest. Rather, the response of stock prices is driven by the impact on expected future excess returns and to some extent on expected future dividends. In this paper, we go a step further by analyzing which factors of these expectations are important for understanding the large heterogeneity in the reaction of individual stocks to monetary policy.

In the literature on the credit channel of monetary policy transmission, Bernanke and Blinder (1992) and Kashyap, Stein, and Wilcox (1993) show that a tightening of monetary policy has a particularly strong impact on firms that are highly bank-dependent borrowers as banks reduce their overall supply of credit. Bernanke and Gertler (1989) and Kiyotaki and Moore (1997) argue that worsening credit market conditions affect firms also by weakening their balance sheets as the present value of collateral falls with rising interest rates, and that this effect can be stronger for some firms than for others. Both arguments are based on information asymmetries: firms for which less information is publicly available may find it more difficult to access bank loans when credit conditions become tighter as banks tend to reduce credit lines first to those customers about whom they have the least information (Gertler and Hubbard, 1988, Gertler and Gilchrist, 1994). For instance, Thorbecke (1997) and Perez-Quiros and Timmermann (2000) show that the response of stock returns to monetary policy is larger for small firms.

If a credit channel is at work for firms that are quoted on stock markets, one would expect that their stock prices respond to monetary policy in a heterogeneous fashion, with the prices of firms that are subject to relatively larger informational asymmetries reacting more strongly. The reason is that their expected future earnings are affected more, since these firms will find it harder to access funds following a monetary tightening, which should lead to a constraint of the supply of their goods. …

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