TAILIEUCHUNG - Does Monetary Policy Affect Stock Prices and Treasury Yields? An Error Correction and Simultaneous Equation Approach

The regression results also imply that expected inflation has a substantial effect on expected long-run real equity returns. In other words, in addition to the negative effect on stock prices associated with its effect on expected earnings, higher expected inflation also raises long- run required returns. Roughly speaking, a one percentage point increase in expected inflation increases required long-run real stock returns about a percentage point; equivalently, it reduces the current price of stocks about 20 percent. At the same time, the analysis suggests that the component of expected stock returns associated with expected inflation is closely related to the components of expected returns associated. | Does Monetary Policy Affect Stock Prices and Treasury Yields An Error Correction and Simultaneous Equation Approach J. Benson Durham Division of Monetary Affairs Board of Governors of the Federal Reserve System Mail Stop 71 20th and C Streets Washington DC 20551 202 452-2896 Abstract This study pursues two addenda to the practitioner and academic on the effect of monetary policy on asset prices. First this paper applies cointegration theory and second relaxes the stringent assumption in the literature that changes in 10-year Treasury yields stock returns and changes in the stance of monetary policy are exogenous. Given quarterly data from 1978 Q4 to 2002 Q3 two-stage least squares 2SLS regressions suggest that changes in the exogenous component of the federal funds rate affect changes in Treasury yields but not stock returns ceteris paribus. However this result is sensitive to alternative proxies for the stance of monetary policy. Also little evidence suggests that monetary policy responds to the exogenous components of changes in financial asset prices. Without implication the author thanks Antulio Bomfim Jim Clouse Darrel Cohen Brian Madigan Athanasios Orphanides and Brian Sack for helpful comments. The views expressed in this paper do not necessarily reflect those of the Board of Governors of the Federal Reserve System or any member of its staff. 1 1. Introduction A large practitioner and academic literature examines the effect of monetary policy on asset prices. Several studies address the impact of monetary policy surprises on daily or intraday stock returns for example while fewer consider longer-run effects on equity prices and Treasury yields. This research question has clear implications for both financial market participants and central bankers. With respect to the former the subject is of course germane to the broader issue of empirical asset pricing and practitioners spend considerable resources following prospective monetary .

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