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  1. 1. Anthony Matarese 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 1
  2. 2. 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 market. 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 2
  3. 3. 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 3
  4. 4. 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. 4
  5. 5. 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 stocks. 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. 5
  6. 6. Works Cited 6
  7. 7. 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. 7

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