December 4, 2006
SMIP – Critical Review & Analysis
Monetary Policy’s Affect on The Stock Market? Why?
Throughout the course of the semester the Economics Group did an excellent job
reporting the current economic circumstances that could possibly affect the Student
Managed Investment Portfolio (SMIP). For instance, the Economics Groups always
mentioned if the Federal Reserve (Fed) was expected to keep interest rates stable, or if
interest rates were expected to increase or decrease. However, the Economics Groups
assumed that everyone in the class knew how monetary policy affects the stock market,
and hence the portfolio of the class. The truth is that many of the students in the SMIP do
not know how monetary policy affects the stock market. Therefore, at the start of next
semester the Economics Group should spend part of the first economic briefing explaining
how monetary policy affects the stock market. This paper will focus on monetary policy,
specifically interest rates, and the affect that interest rates have of the stock market.
While monetary policy may have both positive and negative affects on the stock
market, the main objective of monetary policy is to promote the health of the U.S.
economy. Specifically, the goal of monetary policy is to “promote maximum sustainable
output and employment and to promote stable prices” (Federal Reserve Bank 1).
However, monetary policy’s ability to accomplish the goals stated above is indirect at best.
In fact, the most direct and immediate effects of monetary policy are on the on the
financial markets, including the stock market, government and corporate bong market, and
the foreign exchange market (Bernanke 1).
The most powerful tool of monetary policy is the short-term interest rate; also
know as the “federal funds rate.” Before, explaining how short-term interest rates affect
the stock market, it is important that members of the SMIP know how the Federal Reserve
increases or decreases the federal funds rate. The Fed influences the federal funds rate by
increasing or decreasing the money supply, which can be seen at end of the paper in figure
1. Specifically, the Fed controls the money supply through the purchase and sale of
government securities on the open market. Therefore, if the Fed wants the federal funds
rates to fall, the Fed buys government securities from a bank. To pay the bank the Fed
increases the banks reserves, which is equivalent to increasing the money supply. Simple
economic principles imply that the increased supply of bank reserves causes the federal
funds rate to fall. If the Fed wanted to increase the short-term interest rate, the Fed would
sell government securities, hence decreasing the money supply and increasing the interest
rate. After students have a solid understanding of how the Fed controls short-term interest
rates, the Economics Groups can explain how short-term interest rates affect the stock
This analysis is largely based on a study conducted by Ben Bernanke, which
correlates changes in the federal funds rates to changes in the value of the stock market.
After a discussion of the correlation, the analysis then focuses on why monetary policy
affects that stock market.
If markets are assumed to be efficient, anticipated monetary policy decisions will
already be factored into stock prices (Bernanke 2). Therefore, to determine the effect that
monetary policy has on the stock market Bernanke looked at unanticipated funds rate
changes. Bernanke looked at values of federal funds futures contracts both before and
after a Fed meeting to determine the portion of the funds rate decision that came as a
surprise to investors.
The statistical evidence of Bernanke’s study suggest a “stock price multiplier of
monetary policy of something between three to six”, the higher values corresponding to
changes in interest rates that investors believe to be long lasting (Bernanke 5). In other
words, the evidence suggest that a “surprise easing of 25 basis points will typically cause
broad market indices to rise from between ¾ of a percentage point and 1½ percentage
points” (ibid 5). Moreover, the study found that telecommunications, high-tech, and
durable goods industry stocks are the most sensitive to interest rates and energy and utility
stocks are the least sensitive (ibid 5). So why does monetary policy affect stock prices?
Overall, there are three reasons why interest rates affect stock prices, which
include: news that affects the value of future dividends, news that affects current or future
short-term interest rate, and news that affects that market risk premium (ibid 5). First, to
value future dividends an investor must discount the dividends back to the present,
therefore, higher interest rates implies a lower present value of dividends, and hence a
reduction in the value of the stock (ibid 5). Also higher real interest rates make other
investments such as bonds more attractive, as a result money flows out of the stock market
and into the bond market, causing the price of stocks to fall due to increased supply.
However, lower interest rates would cause the present value of dividends to increase and
money would flow out the bond market and into the stock market, causing stock prices to
rise. Bernanke’s study found that while the effects that monetary policy has on dividends
and real interest rates impact stock market prices, the most significant effect on the stock
market is related to news that affects the market risk premium (ibid 5).
The market risk premium is the extra return or compensation that investors demand
to be willing to hold relatively more risky stock. Precisely, the risk premium as shown in
figure 2, is difference between the return on a portfolio of risky stocks and the return on a
risk free asset, such as a portfolio of government bonds. Table 1 shows the Capital Asset
Pricing Model (CAPM) that can be used to determine the required rate of return for
holding the riskier stock.
Table 1. Capital Asset Pricing Model
Required Return = Risk Free Rate + (Beta x Market Risk Premium)
Market Risk Premium = Expected Market Return – Risk Free Rate
An increase in interest rates causes an increase in the perceived risk premium of
stocks, while a decrease of interest rates causes a decrease in the perceived risk premium of
stocks (ibid 7). The change in the perceived risk premium is the result of a change in risk
associated with holding a stock or a change in people’s willingness to bear risk, or both
(ibid 7). “For a given expected stream of dividend payouts and real interest rates, the risk
premium and hence the return to holding stocks can only rise if the current stock price
falls” (ibid 7).
Why do increasing interest rates make stocks more risky? Consider an
unanticipated monetary tightening, which causes interest rates to increase, hence increasing
the risk premium on stocks. Economic theory suggests that as interest rates increase the
balance sheets of publicly traded firms will weaken (ibid 7). First the firms’ interest cost
increase making payments of variable rate notes more costly. Moreover, as interest rates
increase the weighted average cost of capital increases, causing the cost of investment to
increase. As the cost of investment increases, projects that would have been profitable are
no longer profitable, causing the overall level of investment in the economy to decrease.
As the overall level of investment decreases, output (GDP) falls, raising fears of
unemployment. In general, as interest rates increase consumer spending decreases, as
individuals have more incentive to save money and forego present consumption. This is
detrimental to the profitability of firms, as consumers purchase less of the firms’ goods.
Economic theory suggest that reasons discussed above all contribute to the
increased risk associated with holding a stock during a period of increasing interest rates.
For the opposite reasons, as interest rates fall firms become less risky, causing the market
risk premium to fall. Figure 1 at the end of the paper provides a graph that illustrates the
effects of interest rates on the economy as a whole.
In short, Bernanke’s study found that unanticipated monetary policy tightening
lowers stock prices only to a small degree by decreasing the present value of future
dividend payout and by even less by raising the expected real interest rates. The most
significant affect to stock prices comes from changing the perceived risk premium on
This critical review and analysis can be used as a guide to help future participants
of the Student managed Investment Portfolio (SMIP) gain a better understand of how
monetary policy affects the stock market, and hence the SMIP. The Economics Group
should start-off next semester with an analysis as discussed in this paper. Much of the
economic theory discussed in this paper is not covered and Economics 100, therefore,
many of the members of the SMIP would be enlightened by the analysis conducted in this
paper. The SMIP should feel free to keep a copy of this critical review analysis to be used
by next semesters Economics Group.
Bernanke, Ben. ‘Remarks by Governor Ben S. Bernanke.’ The Federal Reserve Board. 2
October 2003. www.federalreserve.gov. 29 November 2006.
‘What are the tools of U.S. monetary policy? The Federal Reserve Board of San
Francisco. www.frbsf.org 29 November 2006.