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

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.