NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

How the Fed Responds to Stock Market Moves

"An unexpected 5 percent increase in the Standard & Poor's 500 index hikes by just over half the probability of a 25 basis point tightening at the next Federal Open Market Committee Meeting."

Federal Reserve Board Chairman Alan Greenspan famously coined the term "irrational exuberance" back in December 1996. His warning about the economic risks associated with soaring asset prices set off a widespread debate over whether America's central bank should deliberately prick what appeared to be an emerging stock market bubble. Indeed, price-earnings ratios skyrocketed until the bubble eventually burst in the spring of 2000.

Still, there are other broad questions besides whether the central bank should target asset prices that appear to move away from fundamental values. For instance, shifts in the stock market clearly influence the direction of the macroeconomy. Does the Federal Reserve react to stock market movements in setting monetary policy? And if the answer is yes, is the Fed's policy response of the appropriate magnitude? These are the questions that motivate Roberto Rigobon and Brian Sack in Measuring The Reaction of Monetary Policy to the Stock Market (NBER Working Paper No. 8350).

The stock market influences the real economy of goods and services through two main channels. The first is the so-called wealth effect. The total financial wealth of American households stood at a staggering $35.7 trillion at the end of 2000, and stocks accounted for $11.6 trillion of that sum. Consumers might open their wallets a bit more when stock prices are rising smartly, but take fewer trips to the mall if falling stock prices are cutting into household wealth. A bull or bear stock market also affects the cost of financing for business. Last year, U.S. non-financial corporations raised some $118 billion in equity offerings and more than $100 billion in venture capital funds. This year, the comparable figures are much lower.

Of course, teasing out monetary policy responses to the stock market is difficult, especially since the stock market reacts to changes in monetary policy even as that policy responds to shifts in the stock market. But the authors are able to establish a relationship between monetary policy and stock prices

Specifically, they find that an unexpected 5 percent increase in the Standard & Poor's 500 index hikes by just over half the probability of a 25 basis point tightening at the next Federal Open Market Committee Meeting. The same calculation works for a monetary easing. In other words, if the probability of a monetary easing were 30 percent under existing economic conditions, an unexpected 5 percent decline in stock prices would increase the probability of a cut in the Fed's benchmark short-term interest rate to 80 percent. "This reaction is roughly of the magnitude that would be expected from estimates of the impact of stock market movements on aggregate demand," say the authors. "Thus, it appears that the Federal Reserve systematically responds to stock price movements only to the extent warranted by their impact on the macroeconomy."

-- Chris Farrell


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