The Effect of Monetary Policy on Monthly and Quarterly Stock Market Returns: Cross-Country Evidence and Sensitivity Analyses

Abstract

Several studies report an empirical link between changes in monetary policy and short-as well as long-run stock market performance in the United States. Such findings are germane both to the study of market determinants and to monetary policy transmission mechanisms. Previous univariate time-series results on long-run data, which use the discount rate as the main policy indicator, seem robust to alternative specifications of stock price returns given data on 16 countries from 1956 through 2000. However, out-of-sample tests indicate that the relation has largely decreased over time. Also, panel regressions, which notably include cross-sectional variance and therefore are particularly relevant to market participants, suggest that the relation is less sturdy, and consideration of excess as opposed to raw equity price returns in time-series regressions indicates no relation. Finally, alternative measures of central bank policy suggest a weaker and a diminished correlation between monetary policy changes and long-run stock market performance.

Variations in effects of monetary policy on stock market returns in the past four decades

“…None of the three measures of monetary policy's effect on stock prices are found to be statistically significant. The results are in line with Durham's (2001) finding that the U.S. monetary policy could not significantly affect stock prices over the period of 1956-1970. Inflation in the 1960s was low, only about half of the average for the entire sample period.…”

“…Generally speaking, an increase in the funds/discount rates pushes up market-determined interest rates, then leads to a higher cost of capital and lower profitability, causing a negative response from the stock market. Durham, 2001). When innovations in the federal funds rate and nonborrowed reserves are used as the proxies for monetary policy, Thorbecke (1997) finds evidence that monetary policy exerts large effects on ex-ante and ex-post stock market returns.…”

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

“…The nominal federal funds rate is certainly not the only possible proxy for M t . 18 This issue is far from trivial - Durham (2001aDurham ( , 2003 finds that the purported relation between the stance of monetary policy and stock returns is highly sensitive to proxy selection. Therefore, sturdy results should be largely insensitive to proxy selection, and the remainder of this section examines a few alternative variables.…”

“…With respect to the longer-run, Jensen and Johnson (1995) examine monthly and quarterly performance and find that expected stock returns are significantly greater during expansive monetary periods, and Conover et al (1999aConover et al ( , 1999b) make similar inferences using cross-country data. However, Durham (2001aDurham ( , 2003 finds that these findings are highly sensitive to alternative proxies for monetary policy; the use of excess as opposed to raw stock returns; and sample selection, as more recent samples do not produce a statistically significant relation.…”

European monetary policy surprises: the aggregate and sectoral stock market response

“…For example, Cook and Hahn (1989) failed to take account of expected and unexpected changes in monetary policy and so their results are subject to biases as a result of the errors in variables problems. Other longer-term horizon studies that suffer from this problem include Concover et al (1999) and Durham (2001).…”