DYNAMIC INTERACTIONS AMONG THE STOCK MARKET, MONETARY POLICY, INFLATION AND REAL ECONOMIC ACTIVITY Nikiforos T. Laopodis A...
INTRODUCTION <ul><li>. Understanding how monetary policy is transmitted to the economy by affecting the stock market and <...
SOME RESEARCH QUESTIONS <ul><li>To reexamine the issues and determine whether  significant dynamic interdependencies exist...
METHODOLOGICAL DESIGN <ul><li>1. DATA </li></ul><ul><li>. Monthly data on the federal funds rate (FFR), the S&P500 index, ...
<ul><li>2. PRELIMINARY STATISTICS </li></ul><ul><li>a. Descriptive Statistics </li></ul><ul><li>b. Cointegration tests  (J...
<ul><li>Δ FFR i,t = α 1 + γ 1 ε t-1 + Σβ 1,i  Δ FFR i,t + Σβ 2,i  Δ RSP i,t + Σβ 3,i  Δ INF i,t + Σβ 4,i  Δ IP i,t +e 1,t ...
<ul><li>. the best way to summarize the effects of the short- and </li></ul><ul><li>long-run causal relationships between ...
<ul><li>BIVARIATE EMPIRICAL RESULTS AND DISCUSSION </li></ul><ul><li>Real stock returns and real activity </li></ul><ul><l...
<ul><li>1980s </li></ul><ul><li>.  only significant impact on the real activity comes from own past changes </li></ul><ul>...
<ul><li>Real stock returns and interest rate </li></ul><ul><li>1970s </li></ul><ul><li>. significance of two-month lagged ...
<ul><li>1990s </li></ul><ul><li>. E-C terms  are negative & statistically significant; c oefficient </li></ul><ul><li>impl...
<ul><li>Real stock returns and inflation </li></ul><ul><li>1970s </li></ul><ul><li>. the mutual, short-run relationship, h...
<ul><li>CONCLUSIONS FOR BIVARIATE RESULTS </li></ul><ul><li>. we failed to find either a uni- or a bi-directional causalit...
<ul><li>MULTIVARIATE RESULTS AND DISCUSSION </li></ul><ul><li>VEC model for the first decade (1970-79) </li></ul><ul><li>....
<ul><li>.  an explanation for the counterintuitive result of a negative </li></ul><ul><li>relationship between real stock ...
<ul><li>1990s </li></ul><ul><li>. industrial production positively affect the fed funds rate but negatively real stock ret...
<ul><li>DISCUSSION OF FINDINGS </li></ul><ul><li>. we observed both short- and long-run linkages among all four magnitudes...
<ul><li>. although bivariate results for the real stock returns-real activity pair </li></ul><ul><li>uncovered a weak and ...
<ul><li>.  during the 1990s , surges in stock prices could be the result of a series of </li></ul><ul><li>favorable struct...
<ul><li>CONCLUSIONS </li></ul><ul><li>. first, some results for the linkages between real stock returns and </li></ul><ul>...
<ul><li>Table  4.  Bivariate  VAR/VEC Results   Panel A:  Real Stock Returns and Real Activity </li></ul><ul><li>1970:01 -...
<ul><li>Table  5.  Multivariate VAR/VEC Estimates Panel A :  VEC estimates; 1970:01 – 1978:12 </li></ul><ul><li> FFRt    ...
 
 
 
 
 
 
 
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DYNAMIC INTERACTIONS AMONG THE STOCK MARKET, MONETARY POLICY ...

  1. 1. DYNAMIC INTERACTIONS AMONG THE STOCK MARKET, MONETARY POLICY, INFLATION AND REAL ECONOMIC ACTIVITY Nikiforos T. Laopodis Associate Professor of Finance Department of Finance School of Business Fairfield University North Benson Rd. Fairfield, CT 06824, USA Tel. (203) 254 4000 ext. 3273 Fax (203) 254 4105 E-mail: [email_address] * For presentation at the Working Seminars series of the Dept. of Economics at the University of Crete, June 5, 2006.
  2. 2. INTRODUCTION <ul><li>. Understanding how monetary policy is transmitted to the economy by affecting the stock market and </li></ul><ul><li>other macro magnitudes remains one of the most important challenges among economists </li></ul><ul><li>. Several theoretical and empirical frameworks have been proposed in an effort to explain the puzzling </li></ul><ul><li>negative relationships between inflation and real equity returns (Fama, 1981, Geske and Roll, 1983, </li></ul><ul><li>Stultz, 1986, Kaul, 1987, and Lee, 1992, to name a few), between inflation and real interest rates </li></ul><ul><li>(Fama and Gibbons, 1982) and between inflation and real economic activity (Kaul, 1987, Barro, 1990, </li></ul><ul><li>Fama, 1990, and Gallinger, 1994) in the post-war period </li></ul><ul><li>Regarding the causal linkages between monetary policy and stock returns and/or inflation, the evidence </li></ul><ul><li>is mixed </li></ul><ul><li>. Bernanke and Gertler (1999) contend that the central bank should pay attention to asset price inflation </li></ul><ul><li>since the targeting of inflation will stabilize asset prices in turn by contrast, Cogley (1999) goes further by </li></ul><ul><li>suggesting that intentional attempts to deflate asset bubbles may actually destabilize the economy, and </li></ul><ul><li>Bordo and Jeanne (2001) and Fair (2000) argue that traditional monetary policy moves may be unable to </li></ul><ul><li>correct asset price disturbances, while Cecchetti (1998), Chami et al. (1999), and Cecchetti et al. (2000) </li></ul><ul><li>find evidence that central bankers can indeed contribute to economic stability and growth by targeting </li></ul><ul><li>asset prices </li></ul><ul><li>. Filardo (2000) finds little evidence that concentrating on asset prices the Fed can do much to improve the </li></ul><ul><li>economic activity </li></ul><ul><li>Concerning the causal relationship between the stock market and real economic activity, the evidence is </li></ul><ul><li>once again varied </li></ul><ul><li>. Fama (1990, 1991) and Geske and Roll (1983), among others, have pointed out that a large portion of </li></ul><ul><li>stock return variations are explained by future changes in real economic activity; recent evidence (e.g., </li></ul><ul><li>Kwon and Shin, 1999, and Laopodis and Sawhney, 2002) has found either exactly the opposite or that </li></ul><ul><li>such a relationship does not hold during every decade (see also Binswanger, 2000) </li></ul>
  3. 3. SOME RESEARCH QUESTIONS <ul><li>To reexamine the issues and determine whether significant dynamic interdependencies existed among them since the 1970s, decade by decade, within bivariate and multivariate settings </li></ul><ul><li>Has monetary policy been influenced by movements in the stock market or has it been the other way around? </li></ul><ul><li>Has monetary policy during the last three decades been mostly neutral with respect to movements in the equity market? </li></ul><ul><li>Has the Fed’s response been directed primarily towards taming inflationary pressures, as the Fed contends, thereby indirectly affecting the stock market? </li></ul><ul><li>Was the stock market a gambling area during the 1990s and disconnected from the fundamentals? </li></ul>
  4. 4. METHODOLOGICAL DESIGN <ul><li>1. DATA </li></ul><ul><li>. Monthly data on the federal funds rate (FFR), the S&P500 index, the CPI </li></ul><ul><li>and the industrial production index (IP) were collected from DataStream and </li></ul><ul><li>the Federal Reserve’s FRED database for the period of 01/01/1970–12/31/04 </li></ul><ul><li>. The use of the three decades coincides with the terms of the three Federal </li></ul><ul><li>Reserve Board Chairs, Arthur Burns (1970-1978), Paul Volker (1979-1987) </li></ul><ul><li>and Alan Greenspan (1988 to present) </li></ul><ul><li>. Under Burns, inflation in the US increased from 5% in 1970 to about 9% in </li></ul><ul><li>1980. Burns chose to accommodate the building inflationary expectations by </li></ul><ul><li>allowing the money supply to grow rather than accept a costly recession </li></ul><ul><li>. Under Volker’s chairmanship, the Federal Reserve Board reduced inflation by </li></ul><ul><li>lowering the monetary growth rate which sharply increased the interest rate </li></ul><ul><li>. In the 1990s, Greenspan’s idea of monetary policy was to carefully balance </li></ul><ul><li>the use of monetary policy to offset adverse shocks to the economy and the </li></ul><ul><li>anxiety that monetary policy should not be too expansionary (so as to build </li></ul><ul><li>inflationary expectations which may become self-fulfilling) </li></ul>
  5. 5. <ul><li>2. PRELIMINARY STATISTICS </li></ul><ul><li>a. Descriptive Statistics </li></ul><ul><li>b. Cointegration tests (Johansen approach); Results from the Johansen cointegration procedure in Table 2: </li></ul><ul><li>BIVARIATE RESULTS </li></ul><ul><li>no cointegration between: real returns-real activity pair, real returns- </li></ul><ul><li>interest rate pair (in 1st and 2 nd subperiod) but cointegration is </li></ul><ul><li>present in 3rd, real returns-inflation pair is cointegrated in the 1 st </li></ul><ul><li>and 3rd subperiods </li></ul><ul><li>MULTIVARIATE RESULTS </li></ul><ul><li>. one or no common stochastic trend has surfaced that binds together </li></ul><ul><li>in the long-run the federal funds rate, the S&P500, the inflation rate </li></ul><ul><li>and industrial production in 1980s </li></ul><ul><li>. during the 1970s and the 1990s there is a single common stochastic </li></ul><ul><li>trend that bounded the four variables together in the long-run so a </li></ul><ul><li>Vector Error-Correction (VEC) model is appropriate, as follows: </li></ul>
  6. 6. <ul><li>Δ FFR i,t = α 1 + γ 1 ε t-1 + Σβ 1,i Δ FFR i,t + Σβ 2,i Δ RSP i,t + Σβ 3,i Δ INF i,t + Σβ 4,i Δ IP i,t +e 1,t </li></ul><ul><li>Δ RSP i,t = α 2 + γ 2 ε t-1 + Σ δ 1,i Δ FFR i,t + Σ δ 2,i Δ RSP i,t + Σ δ 3,i Δ INF i,t + Σ δ 4,i Δ IP i,t +e 2,t </li></ul><ul><li>Δ INF i,t = α 3 + γ 3 ε t-1 + Σ φ 1,i Δ FFR i,t + Σ φ 2,i Δ RSP i,t + Σ φ 3,i Δ INF i,t + Σ φ 4,i Δ IP i,t +e 3,t </li></ul><ul><li>Δ IP i,t = α 4 + γ 4 ε t-1 + Σ θ 1,i Δ FFR i,t + Σ θ 2,i Δ RSP i,t + Σ θ 3,i Δ INF i,t + Σ θ 4,i Δ IP i,t +e 4,t </li></ul><ul><li>. the short-run dynamics between two variables, say the FFR and the </li></ul><ul><li>RSP, are captured by the  2,i and  1.i coefficients </li></ul><ul><li>. on the other hand, existence of a long-run relationship between the </li></ul><ul><li>federal funds rate and the stock market depends upon the statistical </li></ul><ul><li>significance of  1 and  2 coefficient </li></ul><ul><li>. we also examine the lagged influences(s) of each variable by estimating </li></ul><ul><li>coefficients of  1,i and  2.i </li></ul>
  7. 7. <ul><li>. the best way to summarize the effects of the short- and </li></ul><ul><li>long-run causal relationships between the federal funds rate </li></ul><ul><li>and the stock market is to formulate four interesting </li></ul><ul><li>hypotheses </li></ul><ul><li>Hypothesis 1: Real stock returns ‘Granger-cause’ the </li></ul><ul><li>federal funds rate </li></ul><ul><li>H0:  1 =0 and  2,i =0 for all i and all decades </li></ul><ul><li>Hypothesis 2: Federal funds rate ‘Granger-causes’ real </li></ul><ul><li>stock returns </li></ul><ul><li>H0:  2 =0 and  1,i =0 for all i and all three decades </li></ul><ul><li>Hypothesis 3: Real stock returns ‘Granger-cause’ </li></ul><ul><li>inflation rate </li></ul><ul><li>H0:  3 =0 and  2,i =0 for all i and all three decades </li></ul><ul><li>Hypothesis 4: Real stock returns ‘Granger-cause’ real </li></ul><ul><li>economic activity </li></ul><ul><li>H0:  4 =0 and  2,i =0 for all i and all three decades </li></ul><ul><li>. These hypotheses are tested via an F-test (at the 5% level) </li></ul>
  8. 8. <ul><li>BIVARIATE EMPIRICAL RESULTS AND DISCUSSION </li></ul><ul><li>Real stock returns and real activity </li></ul><ul><li>1970s </li></ul><ul><li>. influence of the stock market appears to become a bit stronger over </li></ul><ul><li>time while the influence of real activity’s own past changes seems to </li></ul><ul><li>drastically diminish over time; </li></ul><ul><li>. var decompositions reveal that for up to 9 periods the forecast error </li></ul><ul><li>variance of stock returns is exclusively accounted for by own </li></ul><ul><li>innovations while real activity’s forecast variance is partly influenced </li></ul><ul><li>by own (91%) and partly by innovations in stock returns (of about </li></ul><ul><li>9%) </li></ul><ul><li>. IRGs show that the response of RSP to shocks in IP is initially </li></ul><ul><li>positive, then negative and takes 7-8 to die out ; responses of IP to </li></ul><ul><li>shocks in RSP, on the other hand, are strongly positive up to the first </li></ul><ul><li>4 months but afterwards the effect is quite mild </li></ul><ul><li>. result consistent with the view that the stock market rationally </li></ul><ul><li>leads changes in real economic activity and that the relationship </li></ul><ul><li>between real stock returns and real activity is positive </li></ul>
  9. 9. <ul><li>1980s </li></ul><ul><li>. only significant impact on the real activity comes from own past changes </li></ul><ul><li>and changes in real stock returns have no influence on the real activity or on </li></ul><ul><li>itself </li></ul><ul><li>. variance decomposition results indicate that over 98%of the error forecast </li></ul><ul><li>in the real stock returns is accounted for by own innovations, whereas almost </li></ul><ul><li>96% of the forecast error variance in the real activity comes from its own </li></ul><ul><li>past innovations and just under 5% of it stems from innovations in the real </li></ul><ul><li>returns </li></ul><ul><li>. IRGs (in Figure 1) show that the responses of the real returns to shocks in </li></ul><ul><li>real activity are negative and take six months to stabilize, while the responses </li></ul><ul><li>of the real activity to innovations in the real returns are positive and seem to </li></ul><ul><li>decay very slowly taking up to eight months to die out </li></ul><ul><li>1990s </li></ul><ul><li>. similarity with results obtained for the 1970s and clearly confirm that the </li></ul><ul><li>real returns-real activity relationship continues to be strong and positive </li></ul><ul><li>. IRGs show a resemblance to that in the 1980s in that they are initially </li></ul><ul><li>negative, then become positive but stabilize after six months </li></ul><ul><li>. similarly, the responses of real activity to shocks by real returns have the </li></ul><ul><li>same pattern as in the last two decades in the sense that they are strongly </li></ul><ul><li>positive, initially, and decay very slowly until they die out after nine or ten </li></ul><ul><li>months </li></ul>
  10. 10. <ul><li>Real stock returns and interest rate </li></ul><ul><li>1970s </li></ul><ul><li>. significance of two-month lagged response of the stock market, suggests a positive impact </li></ul><ul><li>on the fed funds rate, while the two-period lagged response of the fed funds rate affects </li></ul><ul><li>negatively the stock mrkt </li></ul><ul><li>. marginal & reciprocal short-run interdependencies between the two variables </li></ul><ul><li>. IRGs show that the responses of the real returns to shocks in the interest rate are always </li></ul><ul><li>negative and decay very slowly </li></ul><ul><li>. responses of the interest rate to shocks in real returns emerge negative, initially, but </li></ul><ul><li>become positive next until they die out in 9 mos. </li></ul><ul><li>1980s </li></ul><ul><li>. no influence of the federal funds rate on the real returns but the latter surfaces as </li></ul><ul><li>influential and positive on the former only after two months </li></ul><ul><li>. var. decomp. indicates a higher degree of explanatory power for the error forecast </li></ul><ul><li>variance for each variable by own innovations, relative to 1970s, that is, 98% and 93% for </li></ul><ul><li>the real returns and the interest rate </li></ul><ul><li>. IRGs of real returns to innovations from the federal funds rate are initially negative, then </li></ul><ul><li>become positive and die out in seven months </li></ul><ul><li>. a greater turbulence in the responses of the federal funds rate to innovations in the real </li></ul><ul><li>returns since reactions are alternating between + and - before they decay in eight months </li></ul>
  11. 11. <ul><li>1990s </li></ul><ul><li>. E-C terms are negative & statistically significant; c oefficient </li></ul><ul><li>implies that although the federal funds rate and the real returns are </li></ul><ul><li>bound together in an equilibrium in the long run, a booming stock </li></ul><ul><li>market has a negative effect on the federal funds rate </li></ul><ul><li>. regarding the short-run linkages, one- to three-month lagged </li></ul><ul><li>changes in the stock market seem to negatively influence the fed </li></ul><ul><li>funds rate </li></ul><ul><li>. also, a one-month lagged change in the fed funds rate appears to </li></ul><ul><li>adversely affect the stock market </li></ul><ul><li>. results consistent with the view that if the stock market continues </li></ul><ul><li>to record significant gains, then inflationary pressures may begin to </li></ul><ul><li>surface at some future period </li></ul><ul><li>. then, it would force the Fed to pre-empt inflation by increasing the </li></ul><ul><li>federal funds rate and thus depress stock prices </li></ul><ul><li>. IRGs show that the reactions of the real returns to shocks in the </li></ul><ul><li>interest rate start negative but become positive after the third month </li></ul><ul><li>and seem to be ‘well-behaved’ until their decay (at 10th month) </li></ul>
  12. 12. <ul><li>Real stock returns and inflation </li></ul><ul><li>1970s </li></ul><ul><li>. the mutual, short-run relationship, however, is not strong or persistent </li></ul><ul><li>. IRGs of real returns to inflation shocks are minimal initially then become </li></ul><ul><li>negative and ultimately positive until their smooth decay in the 6th month </li></ul><ul><li>. however, the reactions of inflation to shocks in the real returns remain </li></ul><ul><li>negative and flat (without any sharp ups and downs) throughout the period </li></ul><ul><li>1980s </li></ul><ul><li>. no statistically significant relationships between the two magnitudes </li></ul><ul><li>1990s </li></ul><ul><li>. E-C estimates do not show any significant short-run interactions between </li></ul><ul><li>the two magnitudes </li></ul><ul><li>. variance decomposition results indicate that innovations in inflation do not </li></ul><ul><li>have any significant impact on the real stock returns, while innovations in real </li></ul><ul><li>stock returns seem to exert some noticeable impact (of approximately 14%) </li></ul><ul><li>on inflation </li></ul><ul><li>. these observations appear to be confirmed by the IRGs </li></ul>
  13. 13. <ul><li>CONCLUSIONS FOR BIVARIATE RESULTS </li></ul><ul><li>. we failed to find either a uni- or a bi-directional causality </li></ul><ul><li>between stock returns and inflation [like the results found by </li></ul><ul><li>Lee, 1992] </li></ul><ul><li>. furthermore, we did not find a consistent negative response </li></ul><ul><li>of inflation to shocks in real stock returns or a consistent </li></ul><ul><li>negative reaction of real stock returns to inflation shocks </li></ul><ul><li>. these findings, unfortunately add to the relatively </li></ul><ul><li>inconclusive findings by Cohn and Lessard (1981), Gultekin </li></ul><ul><li>(1983) and Boudoukh and Richardson (1993), who either </li></ul><ul><li>found a negative or no significant effects of inflation on </li></ul><ul><li>returns, and by Firth (1979) and Frennberg and Hansson </li></ul><ul><li>(1993), who reported a positive effect of inflation on returns </li></ul>
  14. 14. <ul><li>MULTIVARIATE RESULTS AND DISCUSSION </li></ul><ul><li>VEC model for the first decade (1970-79) </li></ul><ul><li>. E-C estimates for the federal funds rate and inflation rate are </li></ul><ul><li>statistically significant while those for the stock returns and industrial </li></ul><ul><li>production are not </li></ul><ul><li>. past changes in the rate of inflation negatively impact upon the </li></ul><ul><li>federal funds rate, but not the other way around </li></ul><ul><li>. fed funds rate influenced by all other variables even beyond 9 lags </li></ul><ul><li>. industrial production variable seems to be the most exogenous one </li></ul><ul><li>. IRGs: federal funds rate exhibits a more ‘explosive’ behavior </li></ul><ul><li>relative to the other variables, and inflation emerges as the most </li></ul><ul><li>turbulent variable of all, initially, but stabilizes after six months </li></ul><ul><li>. in response to a real activity shock, the federal funds rate and </li></ul><ul><li>inflation trend upwards while the real stock returns downwards </li></ul><ul><li>. thus, we see that the increase in real output depresses real stock </li></ul><ul><li>prices which implies that inflation and real activity are positively </li></ul><ul><li>related but real activity and real stock returns are negatively related </li></ul><ul><li>. this conclusion seems to contradict Fama’s (1981) ‘proxy </li></ul><ul><li>hypothesis’, which says that inflation and real activity are negatively </li></ul><ul><li>related but real activity and real stock returns are positively related </li></ul>
  15. 15. <ul><li>. an explanation for the counterintuitive result of a negative </li></ul><ul><li>relationship between real stock returns and real economic activity </li></ul><ul><li>may be the notion that more good news for a robust economy may </li></ul><ul><li>soon signify an overheating economy, resulting in higher inflation </li></ul><ul><li>and interest rates which, in turn, would lower real equity prices </li></ul><ul><li>1980s </li></ul><ul><li>. cannot see much interaction among the magnitudes but one can </li></ul><ul><li>clearly see that the federal funds rate negatively affects industrial </li></ul><ul><li>production (albeit marginally) and the inflation rate </li></ul><ul><li>. relative exogeneity of industrial production is still present in 1980s </li></ul><ul><li>. similarly, real stock returns do not seem to contain any significant </li></ul><ul><li>information about the funds rate, inflation rate or future economic </li></ul><ul><li>activity as in the 1970s </li></ul><ul><li>. IRGs indicate explosive behavior of the federal funds rate to shocks </li></ul><ul><li>by the other variables and it takes a good 24 months to die off </li></ul><ul><li>. remaining three variables appear to behave well and manage to </li></ul><ul><li>settle within a few months after some ‘mild’ initial turbulence </li></ul>
  16. 16. <ul><li>1990s </li></ul><ul><li>. industrial production positively affect the fed funds rate but negatively real stock returns. </li></ul><ul><li>. inflation does not appear to influence any magnitude within the system either strongly </li></ul><ul><li>and/or persistently (in 1990s inflation was not a concern) </li></ul><ul><li>. in the 2nd half of the decade the Fed increased the federal funds rate and in spite of such </li></ul><ul><li>a policy move, the economy and the stock market recorded spectacular gains due, in part, </li></ul><ul><li>to productivity advances and, in part, to the fact that the Fed gained credibility in having </li></ul><ul><li>tamed inflation </li></ul><ul><li>. this suggests that the Fed took pre-emptive strikes on inflation which fostered robust </li></ul><ul><li>stock market growth and growing optimism about future income prospects </li></ul><ul><li>. real stock returns variable seems to negatively and weakly impact inflation, compared to </li></ul><ul><li>the latter’s influence on the former </li></ul><ul><li>. this is so because if the government runs a budget deficit, due to a fall in economic </li></ul><ul><li>activity resulting in a decline in revenues, and it monetizes that deficit, then as stock prices </li></ul><ul><li>fall (also in response to a decline in economic activity) it will tend to raise inflation expect. </li></ul><ul><li>. real stock returns surface as the main & the largest driver of the innovations in inflation </li></ul><ul><li>. two other interesting observations can be made from IRGs: first, the reactions of the real </li></ul><ul><li>stock returns to shocks from all other variables start and remain negative throughout the </li></ul><ul><li>period, and second, industrial production seems to be the most ‘well-behaved’ variable, in </li></ul><ul><li>terms of exhibiting no or low volatility persistence to shocks from inflation </li></ul>
  17. 17. <ul><li>DISCUSSION OF FINDINGS </li></ul><ul><li>. we observed both short- and long-run linkages among all four magnitudes in </li></ul><ul><li>the 1970s and 1990s but only short-run interdependencies in the 1980s </li></ul><ul><li>. bivariate results (but not the multivariate results, except perhaps for the </li></ul><ul><li>1990s) for the linkages between real stock returns and inflation weakly </li></ul><ul><li>confirm (only present in the 1970s) the (surprising result of a) negative </li></ul><ul><li>correlation between the two magnitudes found by other researchers such as </li></ul><ul><li>Lintner (1975), Jaffe and Mandelker (1976), Fama and Schwert (1977), </li></ul><ul><li>Schwert (1981) and Solnik (1983) to name a few </li></ul><ul><li>. this was in contrast to the widely held view that stock returns were a hedge </li></ul><ul><li>to inflation since they were supposed to be positively correlated with </li></ul><ul><li>(expected and unexpected) inflation, in the short run </li></ul><ul><li>. from multivariate framework results it can be inferred that real stock returns </li></ul><ul><li>were not found to respond positively to monetary easing, which took place </li></ul><ul><li>during the 1990s, and/or negatively to monetary tightening, which happened </li></ul><ul><li>during parts of 1970s and most of the 1980s, as reported in the literature </li></ul><ul><li>. also, we find that the portion of the stock return forecast error variance </li></ul><ul><li>explained by monetary policy (shocks) was very large during the 1970s and </li></ul><ul><li>1990s but smaller during the 1980s </li></ul><ul><li>. these results, however, are in sharp contrast to these by Thorbecke (1997), </li></ul><ul><li>Patelis (1997), and Lastrapes (1998) </li></ul>
  18. 18. <ul><li>. although bivariate results for the real stock returns-real activity pair </li></ul><ul><li>uncovered a weak and negative relationship in the 1970s and 1990s, </li></ul><ul><li>a positive in the 1980s, the multivariate results implied a strong </li></ul><ul><li>relative exogeneity of industrial production in the 1970s and the </li></ul><ul><li>1980s but emerged as a significant impacter of real stock returns </li></ul><ul><li>and the federal funds rate in the 1990s </li></ul><ul><li>. however, lagged values of the other three variables did not seem to </li></ul><ul><li>affect industrial production during the 1990s, although the federal </li></ul><ul><li>funds rate influenced it during both the 1970s and 1980s </li></ul><ul><li>. these conflicting findings do no support the view that real stock </li></ul><ul><li>returns signal changes in future real activity as earlier research noted </li></ul><ul><li>. a suggested interpretation could be that each decade, and </li></ul><ul><li>particularly the 1970s and 1990s, has produced different economic </li></ul><ul><li>fundamentals (structure) such as high inflationary periods with </li></ul><ul><li>supply shocks and speculative bubbles that loosened the link </li></ul><ul><li>between the stock market and economic activity </li></ul><ul><li>. one can cite, for example, the unexplained boom of the equity </li></ul><ul><li>market in the 1990s despite a virtually flat level of real activity (as </li></ul><ul><li>measured here), which implies that the equity market was primarily </li></ul><ul><li>a gambling area indistinct from real economic activity </li></ul>
  19. 19. <ul><li>. during the 1990s , surges in stock prices could be the result of a series of </li></ul><ul><li>favorable structural shifts emanating from magnitudes (or sectors) other than </li></ul><ul><li>the ones studied here (perhaps there is evidence of irrational exuberance) </li></ul><ul><li>. finally, focusing on the important relationship, that is, between monetary </li></ul><ul><li>policy and the stock market, our results seem to suggest that there is no </li></ul><ul><li>concrete and consistent dynamic relationship between the two magnitudes </li></ul><ul><li>since the nature of such dynamics has been different in each decade </li></ul><ul><li>. perhaps this implies that the Fed has never intended to influence the stock </li></ul><ul><li>market in the long run (say, for instance, to accommodate a correction during </li></ul><ul><li>a market decline) or has taken the risk to increase the federal funds markedly </li></ul><ul><li>in order to avert excessive speculation in the market </li></ul><ul><li>. if, in fact, a federal funds policy has been accommodative with respect to </li></ul><ul><li>market overvaluation, then this might have been done inadvertedly by the </li></ul><ul><li>Fed, perhaps in an effort to influence inflation and excess demand (could it be </li></ul><ul><li>‘ irrational exuberance’?) </li></ul><ul><li>. nonetheless, a future study for the recent years of the bear market (2000 to </li></ul><ul><li>present) would have been interesting to see if the Fed has actually caused </li></ul><ul><li>this bear market or not </li></ul>
  20. 20. <ul><li>CONCLUSIONS </li></ul><ul><li>. first, some results for the linkages between real stock returns and </li></ul><ul><li>inflation weakly support a negative correlation between the two </li></ul><ul><li>magnitudes for the 1970s & 1980s </li></ul><ul><li>. second, in regards to the relationship between real stock returns </li></ul><ul><li>and the federal funds rate, the bivariate findings suggest a weak </li></ul><ul><li>negative relationship in the 1970s and 1980s, while the multivariate </li></ul><ul><li>findings indicate strong support of such a linkage in the 1970s </li></ul><ul><li>. third, the bivariate results for the real stock returns-real activity </li></ul><ul><li>pair uncover a weak and negative relationship in the 1970s and </li></ul><ul><li>1990s but a positive one in the 1980s but the multivariate results </li></ul><ul><li>reveal strong exogeneity of industrial production in the 1970s and </li></ul><ul><li>1980s and emerge as a significant precursor to real stock returns </li></ul><ul><li>and the federal funds rate in the 1990s </li></ul><ul><li>. and fourth, focusing on the relationship between monetary policy </li></ul><ul><li>and the stock market, our results seem to suggest that there is no </li></ul><ul><li>concrete and consistent dynamic relationship between the two </li></ul><ul><li>magnitudes since the nature of such dynamics has been different in </li></ul><ul><li>each decade </li></ul>
  21. 21. <ul><li>Table 4. Bivariate VAR/VEC Results Panel A: Real Stock Returns and Real Activity </li></ul><ul><li>1970:01 - 1978:12 1979:01 - 1987:12 1988:01 - 2002:12 </li></ul><ul><li> RSRt  IPt  RSRt  IPt  RSRt  IPt </li></ul><ul><li>Constant 0.0142 0.0077 0.0150* 0.0136 0.0133* 0.0220 (0.112) (0.067) (2.258) (0.010) (2.933) (1.522) </li></ul><ul><li> RSRt-1 0.0219 -0.0067 0.0855 0.0122 -0.1330 0.1112 </li></ul><ul><li> (0.273) (-0.053) (0.074) (0.013) (-1.136) (1.713) </li></ul><ul><li> RSRt-2 -0.0226 0.0252** -0.0789 0.0213 0.0443 0.0349* </li></ul><ul><li>(-0.227) (1.955) (-0.063) (0.024) (0.036) (3.033) </li></ul><ul><li> RSRt-3 0.0321 0.0447* --------- --------- 0.0135 0.0233** </li></ul><ul><li>(0.289) (3.443) (0.135) (1.833) </li></ul><ul><li> IPt-1 0.3126 0.4254* -0.7665 0.2443* 1.9331* 0.0239 </li></ul><ul><li> (0.249) (5.553) (-1.255) (2.633) (2.544) (0.021) </li></ul><ul><li> IPt-2 0.1522 0.0643 -0.1665 0.1448* -0.3345 0.1227* </li></ul><ul><li> (0.118) (1.244) (-0.264) (1.933) (-0.382) (2.221) </li></ul><ul><li> IPt-3 -0.9114** 0.0444 --------- -------- 0.9336 0.2227* </li></ul><ul><li>(-1.889) (0.036) (1.283) (2.333) </li></ul><ul><li>Variance Decomposition </li></ul><ul><li> Lags  RSR  IP  RSR  IP  RSR  IP </li></ul><ul><li> RSR 3 99.6470 0.6522 98.2811 1.6137 94.5581 5.0116 </li></ul><ul><li> 6 96.4270 3.1222 98.1053 1.6936 94.3356 5.4143 </li></ul><ul><li> 9 96.1935 3.4033 98.1042 1.6937 94.2247 5.5252 </li></ul><ul><li> IP 3 1.6116 97.3044 4.0113 95.9346 9.2253 90.4146 </li></ul><ul><li> 6 9.1011 90.8955 4.4119 95.5950 12.6230 87.2969 </li></ul><ul><li> 9 9.8119 90.1660 4.4237 95.5862 12.7238 87.1062 </li></ul>
  22. 22. <ul><li>Table 5. Multivariate VAR/VEC Estimates Panel A : VEC estimates; 1970:01 – 1978:12 </li></ul><ul><li> FFRt  RSRt  INFt  IPt </li></ul><ul><li>E-C -0.0670* 0.0233* 0.0765* -0.0010* </li></ul><ul><li>(-5.462) (2.133) (2.081) (-3.920) </li></ul><ul><li> FFRt-1 0.4129* -0.0736* 0.0444* 0.0572* </li></ul><ul><li> (3.563) (-2.338) (2.623) (3.451) </li></ul><ul><li> FFRt-2 0.3248* -0.0330* 0.0322* 0.0060* </li></ul><ul><li> (2.177) (-3.136) (2.043) (2.372) </li></ul><ul><li> RSRt-1 0.8231* 0.0636* 0.7019* 0.0123* </li></ul><ul><li>(3.211) (2.435) (2.442) (2.772) </li></ul><ul><li> RSRt-2 2.2118* -0.1234* 0.5312* 0.0321* </li></ul><ul><li> (3.234) (-2.545) (2.998) (2.887) </li></ul><ul><li> INFt-1 -0.6210* 0.0344* -0.0213* 0.0067* </li></ul><ul><li> (-2.019) (2.553) (-2.120) (2.966) </li></ul><ul><li> INFt-2 -0.4453* 0.0337* 0.1110* 0.0061* </li></ul><ul><li> (-2.118) (2.039) (2.012) (2.069) </li></ul><ul><li> IPt-1 -0.4420* 0.3644** 0.3113* 0.5767* </li></ul><ul><li> (3.019) (1.933) (2.120) (4.966) </li></ul><ul><li> IPt-2 4.3323* -0.6637 0.6610 0.0761* </li></ul><ul><li> (4.218) (-1.039) (1.012) (3.069) </li></ul>

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