dynamic interactions among the stock market, monetary policy

DYNAMIC INTERACTIONS AMONG THE DYNAMIC INTERACTIONS AMONG THE STOCK MARKET, MONETARY POLICY, STOCK MARKET, MONETARY POLICY,

INFLATION AND REAL ECONOMIC ACTIVITYINFLATION AND REAL ECONOMIC ACTIVITY

Nikiforos T. LaopodisNikiforos T. LaopodisAssociate Professor of FinanceAssociate Professor of Finance

Department of FinanceDepartment of FinanceSchool of BusinessSchool of BusinessFairfield UniversityFairfield UniversityNorth Benson Rd.North Benson Rd.

Fairfield, CT 06824, USAFairfield, CT 06824, USATel. (203) 254 4000 ext. 3273Tel. (203) 254 4000 ext. 3273

Fax (203) 254 4105Fax (203) 254 4105E-mail: E-mail: nlaopodis@mail.fairfield.edunlaopodis@mail.fairfield.edu

* For presentation at the Working Seminars series of the Dept. of * For presentation at the Working Seminars series of the Dept. of Economics at the University of Crete, June 5, 2006. Economics at the University of Crete, June 5, 2006.

INTRODUCTIONINTRODUCTION. Understanding how monetary policy is transmitted to the economy by affecting the stock market and. Understanding how monetary policy is transmitted to the economy by affecting the stock market andother macro magnitudes remains one of the most important challenges among economistsother macro magnitudes remains one of the most important challenges among economists

. Several theoretical and empirical frameworks have been proposed in an effort to explain the puzzling. Several theoretical and empirical frameworks have been proposed in an effort to explain the puzzlingnegative relationships between inflation and real equity returns (Fama, 1981, Geske and Roll, 1983,negative relationships between inflation and real equity returns (Fama, 1981, Geske and Roll, 1983,Stultz, 1986, Kaul, 1987, and Lee, 1992, to name a few), between inflation and real interest ratesStultz, 1986, Kaul, 1987, and Lee, 1992, to name a few), between inflation and real interest rates(Fama and Gibbons, 1982) and between inflation and real economic activity (Kaul, 1987, Barro, 1990,(Fama and Gibbons, 1982) and between inflation and real economic activity (Kaul, 1987, Barro, 1990,Fama, 1990, and Gallinger, 1994) in the post-war periodFama, 1990, and Gallinger, 1994) in the post-war period

Regarding the causal linkages between monetary policy and stock returns and/or inflation, the evidenceRegarding the causal linkages between monetary policy and stock returns and/or inflation, the evidenceis mixedis mixed . Bernanke and Gertler (1999) contend that the central bank should pay attention to asset price inflation. Bernanke and Gertler (1999) contend that the central bank should pay attention to asset price inflationsince the targeting of inflation will stabilize asset prices in turn by contrast, Cogley (1999) goes further bysince the targeting of inflation will stabilize asset prices in turn by contrast, Cogley (1999) goes further bysuggesting that intentional attempts to deflate asset bubbles may actually destabilize the economy, andsuggesting that intentional attempts to deflate asset bubbles may actually destabilize the economy, andBordo and Jeanne (2001) and Fair (2000) argue that traditional monetary policy moves may be unable toBordo and Jeanne (2001) and Fair (2000) argue that traditional monetary policy moves may be unable tocorrect asset price disturbances, while Cecchetti (1998), Chami et al. (1999), and Cecchetti et al. (2000)correct asset price disturbances, while Cecchetti (1998), Chami et al. (1999), and Cecchetti et al. (2000)find evidence that central bankers can indeed contribute to economic stability and growth by targetingfind evidence that central bankers can indeed contribute to economic stability and growth by targetingasset pricesasset prices. Filardo (2000) finds little evidence that concentrating on asset prices the Fed can do much to improve the. Filardo (2000) finds little evidence that concentrating on asset prices the Fed can do much to improve theeconomic activityeconomic activity

Concerning the causal relationship between the stock market and real economic activity, the evidence isConcerning the causal relationship between the stock market and real economic activity, the evidence isonce again variedonce again varied. Fama (1990, 1991) and Geske and Roll (1983), among others, have pointed out that a large portion of. Fama (1990, 1991) and Geske and Roll (1983), among others, have pointed out that a large portion ofstock return variations are explained by future changes in real economic activity; recent evidence (e.g.,stock return variations are explained by future changes in real economic activity; recent evidence (e.g.,Kwon and Shin, 1999, and Laopodis and Sawhney, 2002) has found either exactly the opposite or thatKwon and Shin, 1999, and Laopodis and Sawhney, 2002) has found either exactly the opposite or thatsuch a relationship does not hold during every decade (see also Binswanger, 2000) such a relationship does not hold during every decade (see also Binswanger, 2000)

SOME RESEARCH QUESTIONSSOME RESEARCH QUESTIONS

To reexamine the issues and determine whether significant To reexamine the issues and determine whether significant dynamic interdependencies existed among them since the 1970s, dynamic interdependencies existed among them since the 1970s, decade by decade, within bivariate and multivariate settingsdecade by decade, within bivariate and multivariate settings

Has monetary policy been influenced by movements in the stock Has monetary policy been influenced by movements in the stock market or has it been the other way around? market or has it been the other way around?

Has monetary policy during the last three decades been mostly Has monetary policy during the last three decades been mostly neutral with respect to movements in the equity market?neutral with respect to movements in the equity market?

Has the Fed’s response been directed primarily towards taming Has the Fed’s response been directed primarily towards taming inflationary pressures, as the Fed contends, thereby indirectly inflationary pressures, as the Fed contends, thereby indirectly affecting the stock market?affecting the stock market?

Was the stock market a gambling area during the 1990s and Was the stock market a gambling area during the 1990s and disconnected from the fundamentals?disconnected from the fundamentals?

METHODOLOGICAL DESIGNMETHODOLOGICAL DESIGN

1.1. DATADATA

. Monthly data on the federal funds rate (FFR), the S&P500 index, the CPI. Monthly data on the federal funds rate (FFR), the S&P500 index, the CPIand the industrial production index (IP) were collected from and the industrial production index (IP) were collected from DataStream DataStream andandthe Federal Reserve’s the Federal Reserve’s FREDFRED database for the period of 01/01/1970–12/31/04 database for the period of 01/01/1970–12/31/04

. The use of the three decades coincides with the terms of the three Federal. The use of the three decades coincides with the terms of the three FederalReserve Board Chairs, Arthur Burns (1970-1978), Paul Volker (1979-1987)Reserve Board Chairs, Arthur Burns (1970-1978), Paul Volker (1979-1987)and Alan Greenspan (1988 to present)and Alan Greenspan (1988 to present)

. Under Burns, inflation in the US increased from 5% in 1970 to about 9% in. Under Burns, inflation in the US increased from 5% in 1970 to about 9% in1980. Burns chose to accommodate the building inflationary expectations by1980. Burns chose to accommodate the building inflationary expectations byallowing the money supply to grow rather than accept a costly recessionallowing the money supply to grow rather than accept a costly recession

. Under Volker’s chairmanship, the Federal Reserve Board reduced inflation by. Under Volker’s chairmanship, the Federal Reserve Board reduced inflation bylowering the monetary growth rate which sharply increased the interest ratelowering the monetary growth rate which sharply increased the interest rate

. In the 1990s, Greenspan’s idea of monetary policy was to carefully balance. In the 1990s, Greenspan’s idea of monetary policy was to carefully balancethe use of monetary policy to offset adverse shocks to the economy and thethe use of monetary policy to offset adverse shocks to the economy and theanxiety that monetary policy should not be too expansionary (so as to buildanxiety that monetary policy should not be too expansionary (so as to buildinflationary expectations which may become self-fulfilling)inflationary expectations which may become self-fulfilling)

2.2. PRELIMINARY STATISTICSPRELIMINARY STATISTICS

a.a. Descriptive StatisticsDescriptive Statistics

b.b. Cointegration testsCointegration tests (Johansen approach); Results from the (Johansen approach); Results from the Johansen cointegration procedure in Table 2:Johansen cointegration procedure in Table 2:

BIVARIATE RESULTS BIVARIATE RESULTS

no cointegration between: real returns-real activity pair, real returns-no cointegration between: real returns-real activity pair, real returns-

interest rate pair (in 1st and 2interest rate pair (in 1st and 2nd nd subperiod) but cointegration issubperiod) but cointegration is

present in 3rd, real returns-inflation pair is cointegrated in the 1present in 3rd, real returns-inflation pair is cointegrated in the 1stst

and 3rd subperiods and 3rd subperiods

MULTIVARIATE RESULTSMULTIVARIATE RESULTS

. one or no common stochastic trend has surfaced that binds together. one or no common stochastic trend has surfaced that binds together

in the long-run the federal funds rate, the S&P500, the inflation ratein the long-run the federal funds rate, the S&P500, the inflation rate

and industrial production in 1980sand industrial production in 1980s

. during the 1970s and the 1990s there is a single common stochastic. during the 1970s and the 1990s there is a single common stochastic

trend that bounded the four variables together in the long-run so atrend that bounded the four variables together in the long-run so a

Vector Error-Correction (VEC) model is appropriate, as follows:Vector Error-Correction (VEC) model is appropriate, as follows:

ΔΔFFRFFRi,ti,t==αα1++γγ11εεt-1t-1++ΣβΣβ1,i 1,i ΔΔFFRFFRi,ti,t++ΣβΣβ2,i 2,i ΔΔRSPRSPi,ti,t++ΣβΣβ3,i 3,i ΔΔINFINFi,ti,t++ΣβΣβ4,i 4,i ΔΔIPIPi,ti,t+e+e1,t1,t

ΔΔRSPRSPi,ti,t==αα2++γγ22εεt-1t-1++ΣΣδδ1,i 1,i ΔΔFFRFFRi,ti,t++ΣΣδδ2,i 2,i ΔΔRSPRSPi,ti,t++ΣΣδδ3,i 3,i ΔΔINFINFi,ti,t++ΣΣδδ4,i 4,i ΔΔIPIPi,ti,t+e+e2,t2,t

ΔΔINFINFi,ti,t==αα3++γγ33εεt-1t-1++ΣΣφφ1,i 1,i ΔΔFFRFFRi,ti,t++ΣΣφφ2,i 2,i ΔΔRSPRSPi,ti,t++ΣΣφφ3,i 3,i ΔΔINFINFi,ti,t++ΣΣφφ4,i 4,i ΔΔIPIPi,ti,t+e+e3,t3,t

ΔΔIPIPi,ti,t==αα4++γγ44εεt-1t-1++ΣΣθθ1,i 1,i ΔΔFFRFFRi,ti,t++ΣΣθθ2,i 2,i ΔΔRSPRSPi,ti,t++ΣΣθθ3,i 3,i ΔΔINFINFi,ti,t++ΣΣθθ4,i 4,i ΔΔIPIPi,ti,t+e+e4,t4,t

.. the short-run dynamics between two variables, say the FFR and thethe short-run dynamics between two variables, say the FFR and the

RSP, are captured by the RSP, are captured by the 2,i and 2,i and 1.i coefficients1.i coefficients

. on the other hand, existence of a long-run relationship between the. on the other hand, existence of a long-run relationship between thefederal funds rate and the stock market depends upon the statisticalfederal funds rate and the stock market depends upon the statisticalsignificance of significance of 1 and 1 and 2 coefficient2 coefficient

. we also examine the lagged influences(s) of each variable by estimating. we also examine the lagged influences(s) of each variable by estimatingcoefficients of coefficients of 1,i and 1,i and 2.i2.i

. the best way to summarize the effects of the short- and. the best way to summarize the effects of the short- andlong-run causal relationships between the federal funds ratelong-run causal relationships between the federal funds rateand the stock market is to formulate four interesting and the stock market is to formulate four interesting hypotheseshypothesesHypothesis 1: Real stock returns ‘Granger-cause’ theHypothesis 1: Real stock returns ‘Granger-cause’ the federal funds rate federal funds rate

H0: H0: 1 =0 and 1 =0 and 2,i =0 for all i and all decades2,i =0 for all i and all decadesHypothesis 2: Federal funds rate ‘Granger-causes’ realHypothesis 2: Federal funds rate ‘Granger-causes’ real stock returnsstock returns

H0: H0: 2 =0 and 2 =0 and 1,i =0 for all i and all three decades1,i =0 for all i and all three decadesHypothesis 3: Real stock returns ‘Granger-cause’Hypothesis 3: Real stock returns ‘Granger-cause’ inflation rateinflation rate

H0: H0: 3 =0 and 3 =0 and 2,i =0 for all i and all three decades2,i =0 for all i and all three decadesHypothesis 4: Real stock returns ‘Granger-cause’ realHypothesis 4: Real stock returns ‘Granger-cause’ real economic activityeconomic activity

H0: H0: 4 =0 and 4 =0 and 2,i =0 for all i and all three decades2,i =0 for all i and all three decades

. These hypotheses are tested via an F-test (at the 5% level). These hypotheses are tested via an F-test (at the 5% level)

BIVARIATE EMPIRICAL RESULTS AND DISCUSSIONBIVARIATE EMPIRICAL RESULTS AND DISCUSSION

Real stock returns and real activityReal stock returns and real activity1970s1970s

. . influence of the stock market appears to become a bit stronger overinfluence of the stock market appears to become a bit stronger overtimetime while the influence of real activity’s own past changes seems to while the influence of real activity’s own past changes seems todrastically diminish over time; drastically diminish over time;

. var decompositions reveal that for up to 9 periods the . var decompositions reveal that for up to 9 periods the forecast errorforecast errorvariance of stock returns is exclusively accounted for by ownvariance of stock returns is exclusively accounted for by owninnovationsinnovations while real activity’s forecast variance is partly influenced while real activity’s forecast variance is partly influencedby own (91%) and partly by innovations in stock returns (of aboutby own (91%) and partly by innovations in stock returns (of about9%)9%)

. IRGs show that the . IRGs show that the response of RSP to shocks in IP is initiallyresponse of RSP to shocks in IP is initiallypositive, then negative and takes 7-8 to die outpositive, then negative and takes 7-8 to die out; responses of IP to; responses of IP toshocks in RSP, on the other hand, are strongly positive up to the firstshocks in RSP, on the other hand, are strongly positive up to the first4 months but afterwards the effect is quite mild4 months but afterwards the effect is quite mild

. . result consistent with the view that the stock market rationallyresult consistent with the view that the stock market rationallyleads changes in real economic activity and that the relationshipleads changes in real economic activity and that the relationshipbetween real stock returns and real activity is positivebetween real stock returns and real activity is positive

1980s1980s. . only significant impact on the real activity comes from own past changesonly significant impact on the real activity comes from own past changesand changes in real stock returns have no influence on the real activity or onand changes in real stock returns have no influence on the real activity or onitselfitself. variance decomposition results indicate that over 98%of the error forecast. variance decomposition results indicate that over 98%of the error forecastin the real stock returns is accounted for by own innovations, whereas almostin the real stock returns is accounted for by own innovations, whereas almost96% of the forecast error variance in the real activity comes from its own96% of the forecast error variance in the real activity comes from its ownpast innovations and just under 5% of it stems from innovations in the realpast innovations and just under 5% of it stems from innovations in the realreturnsreturns. IRGs (in Figure 1) show that the responses of the real returns to shocks in. IRGs (in Figure 1) show that the responses of the real returns to shocks inreal activity are negative and take six months to stabilize, while the responsesreal activity are negative and take six months to stabilize, while the responsesof the real activity to innovations in the real returns are positive and seem toof the real activity to innovations in the real returns are positive and seem todecay very slowly taking up to eight months to die out decay very slowly taking up to eight months to die out

1990s1990s. . similarity with results obtained for the 1970s and clearly confirm that thesimilarity with results obtained for the 1970s and clearly confirm that thereal returns-real activity relationship continues to be strong and positivereal returns-real activity relationship continues to be strong and positive. IRGs show a resemblance to that in the 1980s in that they are initially. IRGs show a resemblance to that in the 1980s in that they are initiallynegative, then become positive but stabilize after six monthsnegative, then become positive but stabilize after six months. similarly, the responses of real activity to shocks by real returns have the. similarly, the responses of real activity to shocks by real returns have thesame pattern as in the last two decades in the sense that they are stronglysame pattern as in the last two decades in the sense that they are stronglypositive, initially, and decay very slowly until they die out after nine or tenpositive, initially, and decay very slowly until they die out after nine or tenmonthsmonths

Real stock returns and interest rateReal stock returns and interest rate1970s1970s. significance of two-month lagged response of the stock market, suggests a positive impact. significance of two-month lagged response of the stock market, suggests a positive impacton the fed funds rate, while the two-period lagged response of the fed funds rate affectson the fed funds rate, while the two-period lagged response of the fed funds rate affectsnegatively the stock mrktnegatively the stock mrkt. marginal & reciprocal short-run interdependencies between the two variables. marginal & reciprocal short-run interdependencies between the two variables. IRGs show that the responses of the real returns to shocks in the interest rate are always. IRGs show that the responses of the real returns to shocks in the interest rate are alwaysnegative and decay very slowlynegative and decay very slowly. responses of the interest rate to shocks in real returns emerge negative, initially, but. responses of the interest rate to shocks in real returns emerge negative, initially, butbecome positive next until they die out in 9 mos.become positive next until they die out in 9 mos.

1980s1980s

. no influence of the federal funds rate on the real returns but the latter surfaces as. no influence of the federal funds rate on the real returns but the latter surfaces asinfluential and positive on the former only after two monthsinfluential and positive on the former only after two months. var. decomp. indicates a higher degree of explanatory power for the error forecast. var. decomp. indicates a higher degree of explanatory power for the error forecastvariance for each variable by own innovations, relative to 1970s, that is, 98% and 93% forvariance for each variable by own innovations, relative to 1970s, that is, 98% and 93% forthe real returns and the interest ratethe real returns and the interest rate. IRGs of real returns to innovations from the federal funds rate are initially negative, then. IRGs of real returns to innovations from the federal funds rate are initially negative, thenbecome positive and die out in seven monthsbecome positive and die out in seven months. a greater turbulence in the responses of the federal funds rate to innovations in the real. a greater turbulence in the responses of the federal funds rate to innovations in the realreturns since reactions are alternating between + and - before they decay in eight months returns since reactions are alternating between + and - before they decay in eight months

1990s1990s. E-C terms. E-C terms are negative & statistically significant; c are negative & statistically significant; coefficientoefficientimplies that although the federal funds rate and the real returns areimplies that although the federal funds rate and the real returns arebound together in an equilibrium in the long run, bound together in an equilibrium in the long run, a booming stocka booming stockmarket has a negative effect on the federal funds ratemarket has a negative effect on the federal funds rate. regarding the short-run linkages, . regarding the short-run linkages, one- to three-month laggedone- to three-month laggedchanges in the stock market seem to negatively influence the fedchanges in the stock market seem to negatively influence the fedfunds ratefunds rate. also, a one-month lagged change in the fed funds rate appears to. also, a one-month lagged change in the fed funds rate appears toadversely affect the stock marketadversely affect the stock market. . results consistent with the view that if the stock market continuesresults consistent with the view that if the stock market continuesto record significant gains, then inflationary pressures may begin toto record significant gains, then inflationary pressures may begin tosurface at some future periodsurface at some future period. . then, it would force the Fed to pre-empt inflation by increasing thethen, it would force the Fed to pre-empt inflation by increasing thefederal funds rate and thus depress stock pricesfederal funds rate and thus depress stock prices . IRGs show that the reactions of the real returns to shocks in the. IRGs show that the reactions of the real returns to shocks in theinterest rate start negative but become positive after the third monthinterest rate start negative but become positive after the third monthand seem to be ‘well-behaved’ until their decay (at 10th month)and seem to be ‘well-behaved’ until their decay (at 10th month)

Real stock returns and inflationReal stock returns and inflation1970s1970s. the mutual, short-run relationship, however, is not strong or persistent. the mutual, short-run relationship, however, is not strong or persistent. IRGs of real returns to inflation shocks are minimal initially then become. IRGs of real returns to inflation shocks are minimal initially then become negative and ultimately positive until their smooth decay in the 6th monthnegative and ultimately positive until their smooth decay in the 6th month. however, the reactions of inflation to shocks in the real returns remain. however, the reactions of inflation to shocks in the real returns remainnegative and flat (without any sharp ups and downs) throughout the periodnegative and flat (without any sharp ups and downs) throughout the period

1980s1980s. no statistically significant relationships between the two magnitudes. no statistically significant relationships between the two magnitudes1990s1990s. E-C estimates do not show any significant short-run interactions between. E-C estimates do not show any significant short-run interactions betweenthe two magnitudesthe two magnitudes. variance decomposition results indicate that innovations in inflation do not. variance decomposition results indicate that innovations in inflation do nothave any significant impact on the real stock returns, while innovations in realhave any significant impact on the real stock returns, while innovations in realstock returns seem to exert some noticeable impact (of approximately 14%)stock returns seem to exert some noticeable impact (of approximately 14%)on inflationon inflation. these observations appear to be confirmed by the IRGs. these observations appear to be confirmed by the IRGs

CONCLUSIONS FOR BIVARIATE RESULTSCONCLUSIONS FOR BIVARIATE RESULTS

. we failed to find either a uni- or a bi-directional causality. we failed to find either a uni- or a bi-directional causalitybetween stock returns and inflation [like the results found bybetween stock returns and inflation [like the results found byLee, 1992]Lee, 1992]. furthermore, we did not find a consistent negative response. furthermore, we did not find a consistent negative responseof inflation to shocks in real stock returns or a consistentof inflation to shocks in real stock returns or a consistentnegative reaction of real stock returns to inflation shocksnegative reaction of real stock returns to inflation shocks. these findings, unfortunately add to the relatively. these findings, unfortunately add to the relativelyinconclusive findings by Cohn and Lessard (1981), Gultekininconclusive findings by Cohn and Lessard (1981), Gultekin(1983) and Boudoukh and Richardson (1993), who either(1983) and Boudoukh and Richardson (1993), who eitherfound a negative or no significant effects of inflation onfound a negative or no significant effects of inflation onreturns, and by Firth (1979) and Frennberg and Hanssonreturns, and by Firth (1979) and Frennberg and Hansson(1993), who reported a positive effect of inflation on returns(1993), who reported a positive effect of inflation on returns

MULTIVARIATE RESULTS AND DISCUSSIONMULTIVARIATE RESULTS AND DISCUSSIONVEC model for the first decade (1970-79)VEC model for the first decade (1970-79). E-C estimates for the federal funds rate and inflation rate are. E-C estimates for the federal funds rate and inflation rate arestatistically significant while those for the stock returns and industrialstatistically significant while those for the stock returns and industrialproduction are not production are not . past changes in the rate of inflation negatively impact upon the. past changes in the rate of inflation negatively impact upon thefederal funds rate, but not the other way aroundfederal funds rate, but not the other way around. fed funds rate influenced by all other variables even beyond 9 lags. fed funds rate influenced by all other variables even beyond 9 lags. industrial production variable seems to be the most exogenous one. industrial production variable seems to be the most exogenous one. IRGs: federal funds rate exhibits a more ‘explosive’ behavior. IRGs: federal funds rate exhibits a more ‘explosive’ behaviorrelative to the other variables, and inflation emerges as the mostrelative to the other variables, and inflation emerges as the mostturbulent variable of all, initially, but stabilizes after six monthsturbulent variable of all, initially, but stabilizes after six months. in response to a real activity shock, the federal funds rate and. in response to a real activity shock, the federal funds rate andinflation trend upwards while the real stock returns downwardsinflation trend upwards while the real stock returns downwards. thus, we see that the increase in real output depresses real stock. thus, we see that the increase in real output depresses real stockprices which implies that inflation and real activity are positivelyprices which implies that inflation and real activity are positivelyrelated but real activity and real stock returns are negatively relatedrelated but real activity and real stock returns are negatively related. this conclusion seems to contradict Fama’s (1981) ‘proxy . this conclusion seems to contradict Fama’s (1981) ‘proxy hypothesis’, which says that inflation and real activity are negativelyhypothesis’, which says that inflation and real activity are negativelyrelated but real activity and real stock returns are positively relatedrelated but real activity and real stock returns are positively related

. . an explanation for the counterintuitive result of a negativean explanation for the counterintuitive result of a negativerelationship between real stock returns and real economic activityrelationship between real stock returns and real economic activitymay be the notion that more good news for a robust economy maymay be the notion that more good news for a robust economy maysoon signify an overheating economy, resulting in higher inflationsoon signify an overheating economy, resulting in higher inflationand interest rates which, in turn, would lower real equity pricesand interest rates which, in turn, would lower real equity prices

1980s1980s. cannot see much interaction among the magnitudes but one can. cannot see much interaction among the magnitudes but one canclearly see that clearly see that the federal funds rate negatively affects industrialthe federal funds rate negatively affects industrialproduction (albeit marginally) and the inflation rateproduction (albeit marginally) and the inflation rate. relative . relative exogeneity of industrial production is still present in 1980sexogeneity of industrial production is still present in 1980s. similarly, . similarly, real stock returns do not seem to contain any significantreal stock returns do not seem to contain any significantinformation about the funds rate, inflation rate or future economicinformation about the funds rate, inflation rate or future economicactivity as in the 1970sactivity as in the 1970s. IRGs indicate explosive behavior of the federal funds rate to shocks. IRGs indicate explosive behavior of the federal funds rate to shocksby the other variables and it takes a good 24 months to die offby the other variables and it takes a good 24 months to die off. remaining three variables appear to behave well and manage to. remaining three variables appear to behave well and manage tosettle within a few months after some ‘mild’ initial turbulencesettle within a few months after some ‘mild’ initial turbulence

1990s1990s. industrial production positively affect the fed funds rate but negatively real stock returns.. industrial production positively affect the fed funds rate but negatively real stock returns.. . inflation does not appear to influence any magnitude within the system either stronglyinflation does not appear to influence any magnitude within the system either stronglyand/or persistently (in 1990s inflation was not a concern)and/or persistently (in 1990s inflation was not a concern). . in the 2nd half of the decade the Fed increased the federal funds rate and in spite of suchin the 2nd half of the decade the Fed increased the federal funds rate and in spite of sucha policy move, the economy and the stock market recorded spectacular gains due, in part,a policy move, the economy and the stock market recorded spectacular gains due, in part,to productivity advances and, in part, to the fact that the Fed gained credibility in havingto productivity advances and, in part, to the fact that the Fed gained credibility in havingtamed inflationtamed inflation. this suggests that the Fed took pre-emptive strikes on inflation which fostered robust. this suggests that the Fed took pre-emptive strikes on inflation which fostered robuststock market growth and growing optimism about future income prospects stock market growth and growing optimism about future income prospects . real stock returns variable seems to negatively and weakly impact inflation, compared to. real stock returns variable seems to negatively and weakly impact inflation, compared tothe latter’s influence on the formerthe latter’s influence on the former. this is so because if the government runs a budget deficit, due to a fall in economic. this is so because if the government runs a budget deficit, due to a fall in economicactivity resulting in a decline in revenues, and it monetizes that deficit, then as stock pricesactivity resulting in a decline in revenues, and it monetizes that deficit, then as stock pricesfall (also in response to a decline in economic activity) it will tend to raise inflation expect.fall (also in response to a decline in economic activity) it will tend to raise inflation expect.. real stock returns surface as the main & the largest driver of the innovations in inflation. real stock returns surface as the main & the largest driver of the innovations in inflation. two other interesting observations can be made from IRGs: first, the reactions of the real. two other interesting observations can be made from IRGs: first, the reactions of the realstock returns to shocks from all other variables start and remain negative throughout thestock returns to shocks from all other variables start and remain negative throughout theperiod, and second, industrial production seems to be the most ‘well-behaved’ variable, inperiod, and second, industrial production seems to be the most ‘well-behaved’ variable, interms of exhibiting no or low volatility persistence to shocks from inflation terms of exhibiting no or low volatility persistence to shocks from inflation

DISCUSSION OF FINDINGSDISCUSSION OF FINDINGS. we observed both short- and long-run linkages among all four magnitudes in. we observed both short- and long-run linkages among all four magnitudes inthe 1970s and 1990s but only short-run interdependencies in the 1980sthe 1970s and 1990s but only short-run interdependencies in the 1980s. bivariate results (but not the multivariate results, except perhaps for the. bivariate results (but not the multivariate results, except perhaps for the1990s) for the linkages between real stock returns and inflation weakly1990s) for the linkages between real stock returns and inflation weaklyconfirm (only present in the 1970s) the (surprising result of a) negativeconfirm (only present in the 1970s) the (surprising result of a) negativecorrelation between the two magnitudes found by other researchers such ascorrelation between the two magnitudes found by other researchers such asLintner (1975), Jaffe and Mandelker (1976), Fama and Schwert (1977),Lintner (1975), Jaffe and Mandelker (1976), Fama and Schwert (1977),Schwert (1981) and Solnik (1983) to name a fewSchwert (1981) and Solnik (1983) to name a few. this was in contrast to the widely held view that stock returns were a hedge. this was in contrast to the widely held view that stock returns were a hedgeto inflation since they were supposed to be positively correlated with to inflation since they were supposed to be positively correlated with (expected and unexpected) inflation, in the short run(expected and unexpected) inflation, in the short run. from multivariate framework results it can be inferred that real stock returns. from multivariate framework results it can be inferred that real stock returnswere not found to respond positively to monetary easing, which took placewere not found to respond positively to monetary easing, which took placeduring the 1990s, and/or negatively to monetary tightening, which happenedduring the 1990s, and/or negatively to monetary tightening, which happenedduring parts of 1970s and most of the 1980s, as reported in the literatureduring parts of 1970s and most of the 1980s, as reported in the literature. also, we find that the portion of the stock return forecast error variance. also, we find that the portion of the stock return forecast error varianceexplained by monetary policy (shocks) was very large during the 1970s andexplained by monetary policy (shocks) was very large during the 1970s and1990s but smaller during the 1980s1990s but smaller during the 1980s. these results, however, are in sharp contrast to these by Thorbecke (1997),. these results, however, are in sharp contrast to these by Thorbecke (1997),Patelis (1997), and Lastrapes (1998)Patelis (1997), and Lastrapes (1998)

. although bivariate results for the real stock returns-real activity pair. although bivariate results for the real stock returns-real activity pairuncovered a weak and negative relationship in the 1970s and 1990s,uncovered a weak and negative relationship in the 1970s and 1990s,a positive in the 1980s, the multivariate results implied a strong a positive in the 1980s, the multivariate results implied a strong relative exogeneity of industrial production in the 1970s and therelative exogeneity of industrial production in the 1970s and the1980s but emerged as a significant impacter of real stock returns1980s but emerged as a significant impacter of real stock returnsand the federal funds rate in the 1990sand the federal funds rate in the 1990s. however, lagged values of the other three variables did not seem to. however, lagged values of the other three variables did not seem toaffect industrial production during the 1990s, although the federalaffect industrial production during the 1990s, although the federalfunds rate influenced it during both the 1970s and 1980sfunds rate influenced it during both the 1970s and 1980s. these conflicting findings do no support the view that real stock. these conflicting findings do no support the view that real stockreturns signal changes in future real activity as earlier research notedreturns signal changes in future real activity as earlier research noted. a suggested interpretation could be that each decade, and . a suggested interpretation could be that each decade, and particularly the 1970s and 1990s, has produced different economicparticularly the 1970s and 1990s, has produced different economicfundamentals (structure) such as high inflationary periods withfundamentals (structure) such as high inflationary periods withsupply shocks and speculative bubbles that loosened the linksupply shocks and speculative bubbles that loosened the linkbetween the stock market and economic activitybetween the stock market and economic activity. one can cite, for example, the unexplained boom of the equity. one can cite, for example, the unexplained boom of the equitymarket in the 1990s despite a virtually flat level of real activity (asmarket in the 1990s despite a virtually flat level of real activity (asmeasured here), which implies that the equity market was primarilymeasured here), which implies that the equity market was primarilya gambling area indistinct from real economic activitya gambling area indistinct from real economic activity

. . during the 1990sduring the 1990s, surges in stock prices could be the result of a series of, surges in stock prices could be the result of a series offavorable structural shifts emanating from magnitudes (or sectors) other thanfavorable structural shifts emanating from magnitudes (or sectors) other thanthe ones studied here (perhaps there is evidence of irrational exuberance) the ones studied here (perhaps there is evidence of irrational exuberance)

. finally, focusing on the important relationship, that is, between monetary. finally, focusing on the important relationship, that is, between monetarypolicy and the stock market, our results seem to suggest that there is nopolicy and the stock market, our results seem to suggest that there is noconcrete and consistent dynamic relationship between the two magnitudesconcrete and consistent dynamic relationship between the two magnitudessince the nature of such dynamics has been different in each decadesince the nature of such dynamics has been different in each decade

. perhaps this implies that the Fed has never intended to influence the stock. perhaps this implies that the Fed has never intended to influence the stockmarket in the long run (say, for instance, to accommodate a correction duringmarket in the long run (say, for instance, to accommodate a correction duringa market decline) or has taken the risk to increase the federal funds markedlya market decline) or has taken the risk to increase the federal funds markedlyin order to avert excessive speculation in the marketin order to avert excessive speculation in the market

. if, in fact, a federal funds policy has been accommodative with respect to. if, in fact, a federal funds policy has been accommodative with respect tomarket overvaluation, then this might have been done inadvertedly by themarket overvaluation, then this might have been done inadvertedly by theFed, perhaps in an effort to influence inflation and excess demand (could it beFed, perhaps in an effort to influence inflation and excess demand (could it be‘‘irrational exuberance’?)irrational exuberance’?)

. nonetheless, a future study for the recent years of the bear market (2000 to. nonetheless, a future study for the recent years of the bear market (2000 topresent) would have been interesting to see if the Fed has actually causedpresent) would have been interesting to see if the Fed has actually causedthis bear market or notthis bear market or not

CONCLUSIONSCONCLUSIONS

. first, some results for the linkages between real stock returns and. first, some results for the linkages between real stock returns andinflation weakly support a negative correlation between the twoinflation weakly support a negative correlation between the twomagnitudes for the 1970s & 1980smagnitudes for the 1970s & 1980s. second, in regards to the relationship between real stock returns. second, in regards to the relationship between real stock returnsand the federal funds rate, the bivariate findings suggest a weakand the federal funds rate, the bivariate findings suggest a weaknegative relationship in the 1970s and 1980s, while the multivariatenegative relationship in the 1970s and 1980s, while the multivariatefindings indicate strong support of such a linkage in the 1970sfindings indicate strong support of such a linkage in the 1970s. third, the bivariate results for the real stock returns-real activity. third, the bivariate results for the real stock returns-real activitypair uncover a weak and negative relationship in the 1970s andpair uncover a weak and negative relationship in the 1970s and1990s but a positive one in the 1980s but the multivariate results1990s but a positive one in the 1980s but the multivariate resultsreveal strong exogeneity of industrial production in the 1970s andreveal strong exogeneity of industrial production in the 1970s and1980s and emerge as a significant precursor to real stock returns1980s and emerge as a significant precursor to real stock returnsand the federal funds rate in the 1990sand the federal funds rate in the 1990s. and fourth, focusing on the relationship between monetary policy. and fourth, focusing on the relationship between monetary policyand the stock market, our results seem to suggest that there is noand the stock market, our results seem to suggest that there is noconcrete and consistent dynamic relationship between the twoconcrete and consistent dynamic relationship between the twomagnitudes since the nature of such dynamics has been different inmagnitudes since the nature of such dynamics has been different ineach decadeeach decade

Table 4. Bivariate VAR/VEC ResultsTable 4. Bivariate VAR/VEC Results Panel A: Panel A: Real Stock Returns and Real ActivityReal Stock Returns and Real Activity

1970:01 - 1978:121970:01 - 1978:12 1979:01 - 1987:12 1988:01 - 2002:12 1979:01 - 1987:12 1988:01 - 2002:12

RSRt RSRt IPt IPt RSRt RSRt IPt IPt RSRt RSRt IPt IPt

ConstantConstant 0.0142 0.0077 0.0142 0.0077 0.0150* 0.0136 0.0133* 0.0220 0.0150* 0.0136 0.0133* 0.0220 (0.112) (0.112) (0.067) (0.067) (2.258)(2.258) (0.010) (2.933) (1.522) (0.010) (2.933) (1.522)

RSRt-1 RSRt-1 0.0219 0.0219 -0.0067 -0.0067 0.0855 0.0122 -0.1330 0.1112 0.0855 0.0122 -0.1330 0.1112 (0.273)(0.273) (-0.053) (-0.053) (0.074) (0.013) (-1.136) (1.713)(0.074) (0.013) (-1.136) (1.713)

RSRt-2 RSRt-2 -0.0226-0.0226 0.0252** 0.0252** -0.0789 0.0213 0.0443 0.0349*-0.0789 0.0213 0.0443 0.0349* (-0.227)(-0.227) (1.955) (1.955) (-0.063) (0.024) (0.036) (3.033)(-0.063) (0.024) (0.036) (3.033)RSRt-3 RSRt-3 0.0321 0.0321 0.0447* 0.0447* ------------------ --------- 0.0135 0.0233** --------- 0.0135 0.0233** (0.289)(0.289) (3.443) (3.443) (0.135) (1.833) (0.135) (1.833)IPt-1 IPt-1 0.3126 0.3126 0.4254* 0.4254* -0.7665 0.2443* 1.9331* 0.0239-0.7665 0.2443* 1.9331* 0.0239

(0.249)(0.249) (5.553) (5.553) (-1.255) (2.633) (2.544) (0.021)(-1.255) (2.633) (2.544) (0.021)IPt-2 IPt-2 0.1522 0.1522 0.0643 0.0643 -0.1665 0.1448* -0.3345 0.1227* -0.1665 0.1448* -0.3345 0.1227*

(0.118)(0.118) (1.244) (1.244) (-0.264) (1.933) (-0.382) (2.221)(-0.264) (1.933) (-0.382) (2.221)IPt-3 IPt-3 -0.9114** 0.0444 -0.9114** 0.0444 --------- --------- -------- 0.9336 0.2227* -------- 0.9336 0.2227*

(-1.889)(-1.889) (0.036) (0.036) (1.283) (2.333) (1.283) (2.333)

Variance DecompositionVariance Decomposition Lags Lags RSR RSR IPIP RSR RSR IPIP RSR RSR IPIP

RSR 3 99.6470 0.6522RSR 3 99.6470 0.6522 98.2811 1.6137 98.2811 1.6137 94.5581 5.0116 94.5581 5.0116

66 96.4270 3.1222 96.4270 3.1222 98.1053 1.6936 98.1053 1.6936 94.3356 5.4143 94.3356 5.4143 99 96.1935 3.4033 96.1935 3.4033 98.1042 1.6937 98.1042 1.6937 94.2247 5.5252 94.2247 5.5252

IPIP 3 3 1.6116 97.3044 1.6116 97.3044 4.0113 95.9346 4.0113 95.9346 9.2253 90.4146 9.2253 90.4146 66 9.1011 90.8955 9.1011 90.8955 4.4119 95.5950 4.4119 95.5950 12.6230 87.2969 12.6230 87.2969 99 9.8119 90.1660 9.8119 90.1660 4.4237 95.5862 4.4237 95.5862 12.7238 87.1062 12.7238 87.1062

Table 5. Multivariate VAR/VEC Estimates Panel ATable 5. Multivariate VAR/VEC Estimates Panel A: : VEC estimates; 1970:01 – 1978:12VEC estimates; 1970:01 – 1978:12

FFRt FFRt RSRt RSRt INFt INFt IPt IPt

E-CE-C -0.0670* -0.0670* 0.0233* 0.0233* 0.0765* 0.0765* -0.0010* -0.0010* (-5.462) (2.133)(-5.462) (2.133) (2.081) (-3.920) (2.081) (-3.920) FFRt-1 FFRt-1 0.4129* 0.4129* -0.0736* -0.0736* 0.0444* 0.0572* 0.0444* 0.0572*

(3.563) (3.563) (-2.338) (-2.338) (2.623) (2.623) (3.451) (3.451) FFRt-2 FFRt-2 0.3248* 0.3248* -0.0330* -0.0330* 0.0322* 0.0060* 0.0322* 0.0060* (2.177)(2.177) (-3.136) (-3.136) (2.043) (2.372) (2.043) (2.372) RSRt-1 RSRt-1 0.8231* 0.8231* 0.0636* 0.0636* 0.7019* 0.7019* 0.0123* 0.0123* (3.211)(3.211) (2.435) (2.435) (2.442)(2.442) (2.772) (2.772)RSRt-2 RSRt-2 2.2118* 2.2118* -0.1234* 0.5312* -0.1234* 0.5312* 0.0321* 0.0321* (3.234)(3.234) (-2.545) (-2.545) (2.998) (2.887)(2.998) (2.887)INFt-1 INFt-1 -0.6210* -0.6210* 0.0344* 0.0344* -0.0213* 0.0067* -0.0213* 0.0067*

(-2.019) (-2.019) (2.553) (2.553) (-2.120) (2.966) (-2.120) (2.966) INFt-2 INFt-2 -0.4453* -0.4453* 0.0337* 0.0337* 0.1110* 0.0061* 0.1110* 0.0061*

(-2.118)(-2.118) (2.039) (2.039) (2.012) (2.069) (2.012) (2.069) IPt-1 IPt-1 -0.4420* -0.4420* 0.3644** 0.3644** 0.3113* 0.5767* 0.3113* 0.5767*

(3.019) (3.019) (1.933) (1.933) (2.120) (4.966) (2.120) (4.966) IPt-2 IPt-2 4.3323* 4.3323* -0.6637 -0.6637 0.6610 0.0761* 0.6610 0.0761*

(4.218)(4.218) (-1.039) (-1.039) (1.012) (3.069) (1.012) (3.069)

Panel A: 1970:01-1978:12

- .0 0 1

.0 0 0

.0 0 1

.0 0 2

.0 0 3

.0 0 4

.0 0 5

.0 0 6

.0 0 7

.0 0 8

1 2 3 4 5 6 7 8 9 1 0

IP R S R

R esp onse of I P to C h olesk yO ne S.D . Inn ov ations

-1

0

1

2

3

4

5

1 2 3 4 5 6 7 8 9 1 0

IP R S R

R esp on se of R SR to C h olesk yO ne S.D . In nov ation s

Panel B: 1979:01-1987:12

-1

0

1

2

3

4

5

6

1 2 3 4 5 6 7 8 9 10

RSR IP

Response of RSR to CholeskyOne S.D . Innovations

-.002

.000

.002

.004

.006

.008

1 2 3 4 5 6 7 8 9 10

RS R IP

Response of IP to CholeskyOne S.D . Innovations

Panel C: 1988:01-2002:12

. 0 0 0

.0 0 1

.0 0 2

.0 0 3

.0 0 4

.0 0 5

1 2 3 4 5 6 7 8 9 1 0

IP R S R

R esp onse o f I P to C h o lesk yO ne S.D . I nnov ation s

-1

0

1

2

3

4

5

1 2 3 4 5 6 7 8 9 1 0

IP R S R

R esp onse o f R SR to C ho lesk yO n e S.D . I nn ov ations

Panel A: 1970:01-1978:12

-.1

.0

.1

.2

.3

.4

.5

1 2 3 4 5 6 7 8 9 1 0

F F R R S R

R esponse of F F R to C holesk yO ne S.D . Innovations

-2

-1

0

1

2

3

4

5

1 2 3 4 5 6 7 8 9 1 0

F F R R S R

R esponse of R SR to C holesk yO ne S.D . Innovations

Panel B: 1979:01-1987:12

-0 .2

0 .0

0 .2

0 .4

0 .6

0 .8

1 .0

1 2 3 4 5 6 7 8 9 1 0

F F R R S R

R esp on se o f F F R to C h o lesk yO n e S .D . I n n ov atio n s

- 1

0

1

2

3

4

5

1 2 3 4 5 6 7 8 9 1 0

F F R R S R

R esp on se o f R SR to C h o lesk yO n e S .D . I n n ov ation s

Panel C: 1988:01-2002:12

. 0 0

.0 4

.0 8

.1 2

.1 6

.2 0

1 2 3 4 5 6 7 8 9 1 0

F F R R S R

R esp o n se o f F F R to C h o lesk yO n e S .D . I n n ov ation s

-1

0

1

2

3

4

5

1 2 3 4 5 6 7 8 9 1 0

F F R R S R

R esp o n se o f R SR to C h o lesk yO n e S.D . I n n ov ation s

Panel A: 1970:01-1978:12

-2

-1

0

1

2

3

4

5

1 2 3 4 5 6 7 8 9 1 0

R S R C P I

R esponse of R SR to C holesk yO ne S.D . Innovations

- .2

-.1

.0

.1

.2

.3

1 2 3 4 5 6 7 8 9 1 0

R S R C P I

R esponse of C P I to C holesk yO ne S.D . Innovations

Panel B: 1979:01-1987:12

-2

-1

0

1

2

3

4

5

6

1 2 3 4 5 6 7 8 9 1 0

R S R C P I

R esponse of R SR to C holeskyO ne S.D . Innovations

-.0 5

.0 0

.0 5

.1 0

.1 5

.2 0

.2 5

.3 0

1 2 3 4 5 6 7 8 9 1 0

R S R C P I

R esponse of C P I to C holeskyO ne S.D . Innovations

Panel C: 1988:01-2002:12

- . 0 1

.0 0

.0 1

.0 2

.0 3

.0 4

.0 5

1 2 3 4 5 6 7 8 9 1 0

R S R C P I

R esp on se o f R SR to C h o lesk yO n e S.D . I n n ov ation s

- . 0 5

.0 0

.0 5

.1 0

.1 5

.2 0

.2 5

1 2 3 4 5 6 7 8 9 1 0

R S R C P I

R esp on se o f C P I to C h o lesk yO n e S.D . I n n ov ation s

Panel B: 1979:01 - 1987:12

-0 .4

0 .0

0 .4

0 .8

1 .2

1 .6

1 2 3 4 5 6 7 8 9 1 0

F F RR S R

IPC P I

R esp onse o f F FR to C holesk yO ne S.D . Innov ations

- .0 4

- .0 3

- .0 2

- .0 1

.0 0

.0 1

.0 2

.0 3

.0 4

.0 5

1 2 3 4 5 6 7 8 9 1 0

F F RR S R

IPC P I

R esp onse of R SR to C ho leskyO ne S.D . Innov ations

- .0 0 6

- .0 0 4

- .0 0 2

.0 0 0

.0 0 2

.0 0 4

.0 0 6

.0 0 8

1 2 3 4 5 6 7 8 9 1 0

F F RR S R

IPC P I

R esp onse o f IP to C ho lesk yO ne S.D . I nnov ations

- .0 5

.0 0

.0 5

.1 0

.1 5

.2 0

.2 5

.3 0

1 2 3 4 5 6 7 8 9 1 0

F F RR S R

IPC P I

R esp onse o f C P I to C ho lesk yO ne S.D . Innov ations

Panel C: 1988:01 - 2002:12

-.01

.00

.01

.02

.03

.04

.05

1 2 3 4 5 6 7 8 9 10

RSRFFR

CPIIP

Response of RSR to CholeskyOne S.D. Innovations

-.1

.0

.1

.2

.3

.4

.5

1 2 3 4 5 6 7 8 9 10

RSRFFR

CPIIP

Response of FFR to CholeskyOne S.D. Innovations

-.05

.00

.05

.10

.15

.20

1 2 3 4 5 6 7 8 9 10

RSRFFR

CPIIP

Response of CPI to CholeskyOne S.D. Innovations

-.004

-.002

.000

.002

.004

.006

.008

1 2 3 4 5 6 7 8 9 10

RSRFFR

CPIIP

Response of IP to CholeskyOne S.D. Innovations

Figure 5. Forecasts of the Federal Funds Rate (FFR) and the Real Stock Prices (RSR), 2003:01-2004:12 Panel (a)

0

1

2

3

4

5

2002 2003 2004

Actual FFR (Forecast)

FFR

-16

-12

-8

-4

0

4

8

12

2001 2002 2003 2004

Actual RSR (Forecast)

RSR

Panel (b)

0

1

2

3

4

5

2002 2003 2004

Actual FFR (Forecast Mean)

FFR ± 2 S.E.

-60

-40

-20

0

20

40

60

2001 2002 2003 2004

Actual RSR (Forecast Mean)

RSR ± 2 S.E.