Unstable Relationship between the Fed's Monetary Policy Actions and the U.S. Stock Market

ABSTRACTThe stock market and target federal funds rate is positively related over the long run although the relationship is not stable with unstable time lags. This is consistent with the fact that the Fed usually raises the target interest rate when economic growth is strong and the stock market is in bullish trend, and cuts the interest rate when growth is declining and stock market is in bearish trend. The relationship is apparently negative between the two variables when the stock market was set lagging the interest rate by three years, which may imply an obvious time lag between the two variables. Granger causality tests show that the Fed raises interest rate after the stock market has been rising and cuts interest rate after the stock market has been declining. The relationship between monetary aggregate Ml and stock market is negative, and that between M2 and stock market is positive.Keywords: monetary policy action, stock market trend, time lagsJEL classification: E44 E52, G1(ProQuest: . denotes formulae omitted.)INTRODUCTIONEconomists have been trying to find and explain stock market's respond to the Fed's monetary policy actions. Kuttner (2001) and Bemanke and Kuttner (2005) find that investors react to surprise policy actions. Brown and Cliff (2005), Backer and Wurgler (2006, 2007), Kumar and Lee (2006) and Kurov (2010) show that investors' sentiment play a major role in stock market's reaction to monetary policy actions. Chen and Gu (2011) find that stock market declines immediately after regular Fed announcement on most of the announcement days when change in the target federal funds rate exactly meets the consensus estimate. These researches focus on short-run response of stock market to Fed action. Chen (2007), Basistha and Kurov (2008) and Kurov (2010) find that monetary policy actions have stronger impact on stock market in bearish market trends and in recessions.However, the relationship between the Federal Reserve's monetary policy actions and stock market is not stable. The goals of the Federal Reserve System include economic growth, low unemployment rate, and price stability. The Fed's policy actions for these goals, such as changing money supply and target interest rate of the federal funds, have shown apparent impacts on growth of the economy, inflation rate and unemployment rate. These impacts indirectly affect companies' profit and thus their stock prices. However, the effect of Fed action on these goal variables has time lags, e.g., Mishikin (2010) reports that Fed actions affect the economy with time lags of a year or longer, which makes measuring the effect even more difficult. The stock market usually leads economic cycle by several months. Although condition of the stock market is not explicitly a concern of the Fed, as Alan Greenspan said at a Congress hearing in 1999 that the stock market is not a consideration for the Fed's monetary policy even after he had said "over exuberance" about the stock market bobble in 1997, the Fed with Bemanke being the chairman may actually pay attention to stock market condition as increasingly more economists, including these at the Fed, have recognized the wealth effect of the stock market on consumer behavior and on the economy.During the great bullish market period in the 1990s, The Fed raised the federal funds target rate from 1994 to June 1995, then reduced it moderately and kept the rate at around 5.25 percent until early 2000, even after the stock market crashed and started the great bearish period in March 2000, the Fed raised the rate to 6.5 percent and kept it through the rest of the year. Nine months later, the stock market had declined significantly, then the Fed started cutting the federal hinds target rate in January 2001.In this study we focus on exploring the long-run relationship between the federal funds target rate and the stock market from 1994 to March 2011, we also examine the relationship between monetary aggregates Ml and M2 and the stock market in the period although former Board of Governors chairman Alan Greenspan testified in congress that the Fed would no longer use any monetary aggregates as a guide for conducting monetary policy in January 1994. …