Ben S Bernanke: Monetary policy and the stock market - some empirical
results
Speech by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve
System, at the Fall 2003 Banking and Finance Lecture, Widener University, Chester, Pennsylvania,
2 October 2003.
The references for the speech can be found on the Board of Governors of the Federal Reserve System's website.
* * *
The ultimate objective of monetary policymakers is to promote the health of the U.S. economy, which
we do by pursuing our mandated goals of price stability and maximum sustainable output and
employment. However, the effects of our policy instruments, such as the short-term interest rate, on
these goal variables are indirect at best. Instead, monetary policy actions have their most direct and
immediate effects on the broader financial markets, including the stock market, government and
corporate bond markets, mortgage markets, markets for consumer credit, foreign exchange markets,
and many others. If all goes as planned, the changes in financial asset prices and returns induced by
the actions of monetary policymakers lead to the changes in economic behavior that the policy was
trying to achieve. Thus, understanding how monetary policy affects the broader economy necessarily
entails understanding both how policy actions affect key financial markets, as well as how changes in
asset prices and returns in these markets in turn affect the behavior of households, firms, and other
decisionmakers. Studying these links is an ongoing enterprise of monetary economists both within and
outside the Federal Reserve System.
The link between monetary policy and the stock market is of particular interest. Stock prices are
among the most closely watched asset prices in the economy and are viewed as being highly sensitive
to economic conditions. Stock prices have also been known to swing rather widely, leading to
concerns about possible "bubbles" or other deviations of stock prices from fundamental values that
may have adverse implications for the economy. It is of great interest, then, to understand more
precisely how monetary policy and the stock market are related.
In my talk today, I will report the results of research that I have done on this topic with Kenneth Kuttner
of the Federal Reserve Bank of New York, as well as the findings of some related work done both
within and outside the Federal Reserve System.1 The views I will express today, however, are my own
and not necessarily those of my colleagues on the Federal Open Market Committee (FOMC) or the
Board of Governors of the Federal Reserve System.
In our research, Kuttner and I asked two questions. First, by how much do changes in monetary policy
affect equity prices? As you will see, we focus on changes in monetary policy that are unanticipated by
market participants because anticipated changes in policy should already be discounted by stock
market investors and, hence, are unlikely to affect equity prices at the time they are announced. We
find an effect of moderate size: Monetary policy matters for the stock market but, on the other hand, it
is not one of the major influences on equity prices.
Our second question, both more interesting and more difficult, is, why do changes in monetary policy
affect stock prices? We come up with a rather surprising answer, at least one that was surprising to
us. We find that unanticipated changes in monetary policy affect stock prices not so much by
influencing expected dividends or the risk-free real interest rate, but rather by affecting the perceived
riskiness of stocks. A tightening of monetary policy, for example, leads investors to view stocks as
riskier investments and thus to demand a higher return to hold stocks. For a given path of expected
dividends, a higher expected return can be achieved only by a fall in the current stock price. As we will
see, this finding has interesting implications for several issues, including the role of stock prices in
transmitting the effects of monetary policy actions to the broader economy and the potential
effectiveness of monetary policy in "pricking" putative bubbles in the stock market. I will come back to
these issues at the end of my talk. I start, however, with the problem of measuring the effect of
monetary policy on the stock market.
The Effect of Monetary Policy Actions on the Stock Market
Normally, the FOMC, the monetary policymaking arm of the Federal Reserve, announces its interest
rate decisions at around 2:15 p.m. following each of its eight regularly scheduled meetings each year.
An air of expectation reigns in financial markets in the few minutes before to the announcement. If you
happen to have access to a monitor that tracks key market indexes, at 2:15 p.m. on an announcement
day you can watch those indexes quiver as if trying to digest the information in the rate decision and
the FOMC's accompanying statement of explanation. Then the black line representing each market
index moves quickly up or down, and the markets have priced the FOMC action into the aggregate
values of U.S. equities, bonds, and other assets.
On occasion, if economic conditions warrant, the FOMC may decide to make a change in monetary
policy on a day that falls between regularly scheduled meetings, a so-called intermeeting move.
Intermeeting moves, typically agreed upon during a conference call of the Committee, nearly always
take financial markets by surprise, at least in their precise timing, and they are often followed by
dramatic swings in asset prices.
Even the casual observer can have no doubt, then, that FOMC decisions move asset prices, including
equity prices. Estimating the size and duration of these effects, however, is not so straightforward.
Because traders in equity markets, as in most other financial markets, are generally highly informed
and sophisticated, any policy decision that is largely anticipated will already be factored into stock
prices and will elicit little reaction when announced. To measure the effects of monetary policy
changes on the stock market, then, we need to have a measure of the portion of a given change in
monetary policy that the market had not already anticipated before the FOMC's formal announcement.
Fortunately, the financial markets themselves are a source of useful information about monetary policy
expectations. As you may know, the FOMC implements its decisions about monetary policy by
changing its target for a particular short-term interest rate, the federal funds rate. The federal funds
rate is the rate at which depository institutions borrow and lend reserves to and from each other
overnight; although the Federal Reserve does not control the federal funds rate directly, it can do so
indirectly by varying the supply of reserves available to be traded in this market. Since October 1988,
financial investors have been able to hedge and speculate on future values of the federal funds rate by
trading contracts in a futures market, overseen by the Chicago Board of Trade. Investors in this market
have a strong financial incentive to try to guess correctly what the federal funds rate will be, on
average, at various points in the future. The existence of a market in federal funds futures is a boon
not only to investors, such as banks, which want to protect themselves against changes in the cost of
reserves, but also to both policymakers and researchers, because it allows any observer to infer from
the sale prices of futures contracts the values of the federal funds rate that market participants
anticipate at various future dates.2 Previous research (Krueger and Kuttner, 1996; Owens and Webb,
2001) has shown that participants in this market collectively do a good job of forecasting future values
of the funds rate, efficiently incorporating available information about likely future monetary policy
actions.3
By using data from the federal funds futures market, then, it is possible to estimate the value at which
financial market participants expect the FOMC to set its target for the federal funds rate on any given
date. By comparing this expected value to what the FOMC actually did at each date, we can determine
the portion of the Fed's interest rate decision that came as a surprise to financial markets. In our
research, Kuttner and I considered all the dates of scheduled FOMC meetings plus all the dates on
which the FOMC changed the federal funds rate between meetings, or made intermeeting moves, for
the period May 1989 through December 2002, amounting to a total of 131 observations.4 For each of
these dates, we used the expected value of the federal funds rate as inferred from the futures market
to divide the actual change in the federal funds rate on that day into the part that was anticipated by
the markets and the part that was unanticipated.5 So, for example, on November 6, 2002, the Federal
Reserve cut the federal funds rate by 50 basis points. (A basis point equals 1/100 of a percentage
point, so a 50-basis-point cut equals a cut of 1/2 percentage point.) However, this cut in the federal
funds rate was not entirely unexpected; indeed, according to the federal funds futures market,
investors were expecting a cut of about 31 basis points, on average, from the Fed at that meeting.6
So, of the 50 basis points that the FOMC lowered its target for the federal funds rate last November 6,
only 19 basis points were a surprise to financial markets and thus should have been expected to affect
asset prices. Note, by the way, that if the Fed had not changed interest rates at all that day, our
method would have treated that action as the equivalent of a surprise tightening of policy of 31 basis
points because the Fed would have done nothing while the market was expecting an easing of 31
basis points.
To evaluate the effect of monetary policy on the stock market, we looked at how broad measures of
stock prices moved on days on which the Fed made unanticipated changes to policy. I can illustrate
our method by continuing the example of the Fed's cut in the federal funds rate last November 6. On
that day, the broad stock market index we used in our study (the value-weighted index constructed by
the Center for Research in Securities Prices at the University of Chicago) rose in value by 0.96
percentage point. Dividing the 96-basis-point gain in the stock market by the 19-basis-point downward
surprise in the funds rate, we obtain a value of approximately 5 for the "stock price multiplier" relating
policy changes to stock market changes. If this one day were representative, we would conclude that
each basis point of surprise monetary easing leads to about a 5-basis-point increase in the value of
stocks. Or, choosing magnitudes that might be more helpful to the intuition, we could just as well say
that a surprise cut of 25 basis points in the federal funds rate should lead the stock market to rise, on
the same day, about 1.25 percentage points--about 120 points on the Dow Jones index at its current
value. In fact, applying a formal regression analysis to the full sample from 1989 to 2002, we found a
number fairly close to this one, namely, a stock price multiplier for monetary policy of about 4.7. We
also found, as expected, that changes in monetary policy that were anticipated by the market had
small and statistically unimportant effects on stock prices, presumably because these changes had
already been priced into stocks.7
Although a stock price multiplier of about five for unanticipated changes in the federal funds rate is
certainly not negligible, we should appreciate that unexpected changes in monetary policy account for
a tiny portion of the overall variability of the stock market. Unanticipated movements in the federal
funds rate of 20 basis points or more are relatively rare (we observed only thirteen examples in our
fourteen-year sample). Yet the change of one percent or so in the stock market induced by the typical
20-basis-point "surprise" in the funds rate is swamped by the overall variability of stock prices. For
example, over the past five years, the broad stock market has moved one percent or more on about
40 percent of all trading days. Thus, news about monetary policy contributes very little to the
day-today fluctuations in stock prices.
We explored our empirical results with some care. We noted, for example, that a few of the monetary
policy changes in our sample were followed by what seemed to be excessive or otherwise unusual
stock market responses. A number of these responses occurred rather recently, during the Fed's
series of rate cuts in 2001. The Fed's surprise intermeeting cuts of 50 basis points each on January 3
and April 18 of that year were both greeted euphorically by the stock market, with one-day increases in
stock values of 5.3 percent and 4.0 percent, respectively. By contrast, the rate cut of 50 basis points
5
That the Federal Reserve has only been formally announcing its policy moves since 1994 added a measure of complexity to
our research. Before then, market participants generally did not become aware of the FOMC's policy decisions until those
decisions were actually implemented in the market for bank reserves, often the day after the FOMC decision. To the extent
possible, we dated the policy change as of the day that the market would have become aware of it, not the day of the
decision itself. See the paper for details.
6
Investors would not literally expect the Fed to cut the funds rate by 31 basis points, since the Fed usually moves in
25-basispoint increments. An average expectation of a 31-basis-point cut would be consistent with, for example, 62 percent of
investors expecting a 50-basis-point and 38 percent expecting no cut.
7
In principle, news other than the policy decision might affect the federal funds futures contract during the day, so that the
measure of unanticipated policy changes we use here might be a "noisy" one. If so, our approach would underestimate the
effect of policy changes on the stock market. However, Poole, Rasche and Thornton (2002, pp. 68-69) perform an analysis
that suggests that the mismeasurement may be small in practice. Further confirmation is provided by D'Amico and Farka
(2002), who find results similar to ours using ten-minute windows around the announcement; the benefit of a tight window is
that the policy announcement is highly likely to dominate movements in the contract over that period.
BIS Review 42/2003 3
on March 20, 2001, was received less enthusiastically. Even though the cut was more or less what the
futures market had been anticipating, the financial press reported that many equity market participants
were "disappointed" that the rate cut hadn't been an even larger 75-basis-point action. In any event,
the market lost more than 2 percent that day.
To ensure that our results did not depend on a few unusual observations, or "outliers," we re-ran our
regression, omitting the days with the most extreme or unusual market moves. This more conservative
analysis led to a smaller estimate of the effect of policy actions on the stock market, a stock price
multiplier of about 2.6 rather than 4.7. However, the effect remains quite sharp in statistical terms.8
We considered other variations as well. For example, we investigated whether the magnitude of the
effect on the stock market of a surprise policy tightening (that is, an increase in interest rates) differs
from that of a surprise easing of comparable size. It does not. Yet another experiment consisted of
asking whether an unanticipated policy change has a larger effect if it is thought by the market to
signal a longer-lasting change in policy. We measured the perceived permanence of policy changes
by observing the effects of unanticipated policy changes on the expected federal funds rate three
months in the future, as measured by the futures market. The stock market multiplier associated with
unanticipated policy moves that are perceived to be more permanent is a bit higher, as would be
expected; its value is about 6.9
In short, the statistical evidence is strong for a stock price multiplier of monetary policy of something
between 3 and 6, the higher values corresponding to policy changes that investors perceive to be
relatively more permanent. That is, according to our findings, a surprise easing by the Fed of 25 basis
points will typically lead broad stock indexes to rise from between 3/4 percentage point and 1-1/2
percentage points. Incidentally, similar results obtain for stock values of industry groups: We find
almost all industry stock portfolios respond significantly to changes in monetary policy, with
telecommunications, high-tech, and durables goods industry stocks being the most sensitive to
monetary policy news, and energy, utilities, and health care stocks being the least sensitive.10 These
results can be broadly explained by the tendency of each industry group to move with the broad
market, or (to use the language of the standard capital asset pricing theory), by their industry "betas."
Why Does Monetary Policy Affect Stock Prices?
It is interesting, though perhaps not terribly surprising, to know that Federal Reserve policy actions
affect stock prices. An even more interesting question, though, is, why does this effect occur?
Answering this question will give us some insight into how monetary policy affects the economy, as
well as the role that the stock market should play in policy decisions.
A share of stock is a claim on the current and future dividends (or other cash flows, such as stock
buybacks) to be paid by a company. Suppose, for just a moment, that financial investors do not care
about risk. Then only two types of news ought to affect current stock values: news that affects investor
forecasts of current or future (after-tax) dividends or news that affects forecasts of current or future
short-term interest rates. News that current or future dividends (which I want to think of here as being
measured in real, or inflation-adjusted, terms) are likely to be higher than previously expected--say,
because the company is expecting to be more profitable--should raise the current stock price. News
8
Technically, we removed outlier observations based on their so-called influence statistics, which measure the importance of
individual observations to the overall results. Another correction was needed because, in the early part of the sample,
particularly between 1989 and 1992, it was not uncommon for intermeeting rate cuts to take place on the same day that the
government issued weaker-than-expected reports about employment growth. In such cases, our method cannot distinguish
cleanly between the effects of the employment news and the effects of the rate cut itself on the stock market. If we eliminate
both the outlier observations and the observations in which employment reports coincided with rate changes, we find the
multiplier effect of policy changes on the stock market to be about 3.6 and again statistically significant.
9
To focus on policy surprises of longer duration, Rigobon and Sack (2002) derive their measure of the unexpected policy
change on the three-month eurodollar deposit rate, rather than the current month's federal funds rate, as in this paper and in
Kuttner (2001). Using a methodology that also attempts to correct for two-way causality between the funds rate and asset
prices, and data for post-1993 scheduled FOMC meetings and Chairman's testimony dates only, they find comparable
though slightly higher values for the effect of monetary policy on the stock market. For example, they find a policy multiplier
for the Standard and Poor's 500 index of 7.7. However, when they use data on the federal funds rate futures market to
measure policy shocks, Rigobon and Sack find results similar to ours, using their sample and methodology.
10
Using methods similar to ours, Guo (2002) found that the impact of monetary policy actions on stock prices does not seem
to depend on firm size.
4 BIS Review 42/2003
that current or future short-term interest rates (also measured in real, or inflation-adjusted, terms) are
likely to be higher than previously expected should depress the stock price. There are two essentially
equivalent ways of understanding why expectations of higher short-term real interest rates should
lower stock prices. First, to value future dividends, an investor must discount them back to the present;
as higher interest rates make a given future dividend less valuable in today's dollars, higher interest
rates reduce the value of a share of stock. Second, higher real interest rates make investments other
than stocks, such as bonds, more attractive, raising the required return on stocks and reducing what
investors are willing to pay for them. Under either interpretation, expectations of higher real interest
rates are bad news for stocks.
So, to reiterate, in a world in which investors do not care about risk, stock prices should change only
with news about current or future dividends or about current or future real interest rates. However,
investors do care about risk, of course. Because investors care about risk, and because stocks are
viewed as relatively risky investments, investors generally demand a higher average return, relative to
other assets perceived to be safer, to hold stocks. Using long historical averages, one finds that, in the
United States, a diversified portfolio of stocks has paid 5 to 6 percentage points more per year, on
average, than has a portfolio of government bonds. This extra return, known as the risk premium on
stocks, or the equity premium, presumably reflects, in part, the extra compensation that investors
demand to be willing to hold relatively more risky stocks.11
Like news about dividends and real interest rates, news that affects the risk premium on stocks also
affects stock prices. For example, news of an impending recession could raise the risk premium on
stocks in two ways. First, the macroeconomic environment is more volatile than usual during a
recession, so stocks themselves may become riskier investments. Second, the incomes and wealth of
financial investors tend to fall during a downturn, giving them a smaller cushion to support the lifestyles
to which they are accustomed (that is, to make house payments and meet other obligations). With less
discretionary income and wealth to absorb potential losses, people may become less willing to bear
the risks of more volatile financial investments (Campbell and Cochrane, 1999). For both reasons, the
extra return that investors demand to hold stocks is likely to rise when bad times loom. With expected
dividends and the real interest rate on alternative assets held constant, the expected yield on stocks
can rise only through a decline in the current stock price.12
We now have a list of three key factors that should affect stock prices. First, news that current or future
dividends will be higher should raise stock prices. Second, news that current or future real short-term
interest rates will be higher should lower stock prices. And third, news that leads investors to demand
a higher risk premium on stocks should lower stock prices.
How does all this relate to the effects of monetary policy on stock prices? According to our analysis,
Fed actions should affect stock prices only to the extent that they affect investor expectations about
dividends, short-term real interest rates, or the riskiness of stocks. The trick is to determine
quantitatively which of these sets of investor expectations is likely to be most affected when the Fed
unexpectedly changes the federal funds rate.
To make this determination, we used a methodology first applied by the financial economist John
Campbell, of Harvard University, and by Campbell and John Ammer of the Federal Reserve Board
staff (Campbell, 1991; Campbell and Ammer, 1993). Putting the details aside, we can describe the
basic idea as follows. Imagine that the expectations of stock market investors can be mimicked by a
statistical forecasting model that takes relevant current data as inputs and projects estimated future
values of aggregate dividends, real interest rates, and equity risk premiums as outputs. In principle,
investors could use such a model to make forecasts of these key variables and hence to estimate
what they are willing to pay for stocks. Besides a number of standard variables that have been shown
to be helpful in making forecasts of such financial variables, suppose we include in the forecasting
model our measure of unanticipated changes in the federal funds rate.13 That is, we use the
information contained in these unanticipated changes in making our forecasts of future dividends,
interest rates, and risk premiums.
Now we can consider the following thought experiment. Suppose we have run our computer model,
made our forecasts, and inferred the appropriate values for stocks. But then we receive news that the
Fed has unexpectedly raised the federal funds rate by 25 basis points. Based on our forecasting
model, by how much would that information change our previous forecasts of future dividends, interest
rates, and risk premiums? The answer to this question clarifies the channel by which monetary policy
affects stock prices. If we were to find, for example, that the news of an unexpected increase in the
funds rate significantly changed the forecast of future dividends but did not much affect the forecasts
of interest rates or risk premiums, then we could conclude that monetary policy affects stock prices
primarily by affecting investor expectations of future dividends. By contrast, if news of the policy action
changed the model forecasts for real interest rates but did not change our forecasts for the other two
variables, we would decide that unanticipated policy actions affect stock prices primarily by influencing
the interest rates expected by stock investors.
What we actually found when conducting this statistical experiment was quite interesting. It appears
that, for example, an unanticipated tightening of monetary policy leads to only a modest change in
forecasts of future dividends and to still less of a change in forecasts of future real interest rates
(beyond a few quarters). Quantitatively, according to our methodology, the most important effect of a
policy tightening is on the forecasted risk premium. Specifically, an unanticipated tightening of
monetary policy raises expected risk premiums on stocks for a protracted period. For a given expected
stream of dividend payouts and real interest rates, the risk premium and hence the return to holding
stocks can only rise if the current stock price falls.
In short, our analysis suggests that an unanticipated monetary tightening lowers stock prices only to a
small extent by lowering investor expectations about future dividend payouts, and by still less by
raising expected real interest rates. The most powerful effect of an unanticipated monetary tightening
is to increase the perceived risk premium on stocks, either by increasing the riskiness of stocks, by
reducing people's willingness to bear risk, or both. Reduced willingness of investors to hold relatively
more risky stocks drives down stock prices.
Our analysis does not explain precisely how monetary policy affects risk, but we can make reasonable
conjectures. For example, tighter monetary policy may raise the riskiness of shares themselves by
raising the interest costs and weakening the balance sheets of publicly owned firms (Bernanke and
Gertler, 1995). In the macroeconomy more generally, by reducing spending and economic activity,
tighter money raises the risks of unemployment or bankruptcy faced by individual households or firms.
In each case, tighter monetary policy increases risk by reducing financial buffers or otherwise
increasing the vulnerability of individuals or firms to future shocks to the economy.
Implications of the Results for Monetary Policy
So far I have discussed two principal conclusions from the empirical analysis: First, the stock price
multiplier of monetary policy is between 3 and 6--in other words, an unexpected change in the federal
funds rate of 25 basis points leads, on average, to a movement of stock prices in the opposite
direction of between 3/4 percentage point and 1-1/2 percentage points. Second, the main reason that
unanticipated changes in monetary policy affect stock prices is that they affect the risk premium on
stocks. In particular, a surprise tightening of policy raises the risk premium, lowering current stock
prices, and a surprise easing lowers the risk premium, raising current stock prices.
What implications do these results have for our broader understanding and for the practice of
monetary policy? I will briefly discuss two issues: first, the role of the stock market in the transmission
of monetary policy changes to the economy; and second, the efficacy of monetary policy as a tool for
controlling stock market "bubbles."
A long-held element of the conventional wisdom is that the stock market is an important part of the
transmission mechanism for monetary policy. The logic goes as follows: Easier monetary policy, for
example, raises stock prices. Higher stock prices increase the wealth of households, prompting
consumers to spend more--a result known as the wealth effect. Moreover, high stock prices effectively
reduce the cost of capital for firms, stimulating increased capital investment. Increases in both types of
spending--consumer spending and business spending--tend to stimulate the economy.
This simple story can be elaborated somewhat in light of our results. It is true, as I have discussed,
that an easier monetary policy raises stock prices, whereas a tighter policy lowers them. However,
easier monetary policy not only raises stock prices; as we have seen, it also lowers risk premiums,
presumably reflecting both a reduction in economic and financial volatility and an increase in the
capacity of financial investors to bear risk. Thus, our results suggest that easier monetary policy not
only allows consumers to enjoy a capital gain in their stock portfolios today, but it also reduces the
effective amount of economic and financial risk they must face. This reduction in risk may cause
consumers to trim their precautionary saving, that is, to reduce the amount of income that they put
aside to protect themselves against unforeseen contingencies. Reduced precautionary saving in turn
implies more spending by households. Thus, the reduction in risk associated with an easing of
monetary policy and the resulting reduction in precautionary saving may amplify the short-run impact
of policy operating through the traditional channel based on increased asset values. Likewise, reduced
risk and volatility may provide an extra kick to capital expenditure in the short run, as firms are more
likely to undertake investments in new structures or equipment in a more stable macroeconomic
environment.14
A second issue concerns the role of monetary policy in the management of large swings in stock
values, or "bubbles." In an earlier speech (Bernanke, 2002), I gave a number of reasons why I believe
that using monetary policy--as opposed to microeconomic, prudential policies--is not a good way to
address the problem of asset-market bubbles. These included the difficulty of identifying bubbles in
advance; the questionable wisdom, in the context of a free-market economy, of setting up the central
bank as the arbiter of asset values; the problem that arises when a bubble occurs in only one asset
class rather than in all asset classes; and other reasons. A major concern that I have about the
bubble-popping strategy, however, is that attempts to bring down stock prices by a significant amount
using monetary policy are likely to have highly deleterious and unwanted side effects on the broader
economy. The research I have described today allows me to address this issue more concretely. Here
I will make just two points.
First, this research suggests that relatively small changes in monetary policy would not do much to
curb a major overvaluation in the stock market. As we have seen, a surprise tightening of 25 basis
points should be expected to lower stock prices by only a little more than 1 percent, which, as already
noted, is a trivial movement relative to the overall variability of the stock market. It would not be
appropriate to extrapolate these results to try to estimate how much tightening would be needed to
correct a substantial putative overvaluation in stock prices, but it seems clear that a light tapping of the
brakes will not be sufficient. What we can say is that the necessary policy move would have to be