The Asset Price Transmission Mechanism -The Affect Of The Federal Funds Rate

On Asset Prices

Elizabeth Gonzalez

Monetary Policy and Asset Prices

Two Main Asset Price Channels:– Stock Prices– Real Estate Prices

Monetary policy can:– Cause asset price booms– Be used to defuse asset price bubbles before

they cause macroeconomic instability

Stock Market Prices

Effect on investment– Tobin’s q – market value of a firm divided by the firm’s

replacement cost of capital– As interest rates are decreased, bonds become less attractive

relative to stocks, which increases the price of stocks↑ Money Supply ↑ Stock Prices ↑ Tobin’s q ↑ Investment ↑ Output

Firm’s balance sheet effects– Lower net worth firms have less collateral for loans

Leads to risky business and less lending to these companies↑ Money Supply ↑ Stock Prices ↑ Firms’ Net Worth ↑ Lending ↑ Investment ↑ Output

Stock Market Prices

Household liquidity effects– More likely to hold liquid assets when under

financial distress↑ Money Supply ↑ Stock Prices ↑ Consumers’ Financial Assets

↓ Likelihood of Financial Distress ↑ Expenditure on Housing and Consumer Durables ↑ Output

Household wealth effects↑ Money Supply ↑ Stock Prices ↑ Consumer Wealth ↑ Consumption ↑ Output

Real Estate Prices

Direct effect on housing expenditures– As the money supply increases, the cost of

financing decreases, which leads to higher prices↑ Money Supply ↑ Housing Prices ↑ Housing Expenditures ↑ Output

Household wealth effects– As home values increase, so does household

wealth.↑ Money Supply ↑ Housing Prices ↑ Household Wealth ↑ Consumption ↑ Output

Real Estate Prices

Bank balance sheet effects– Big share of bank’s business in mortgage loans– Increase in money supply and higher mortgages

means that banks have more capital to lend out↑ Money Supply ↑ Real Estate Prices ↑ Bank Capital

↑ Lending ↑ Investment ↑ Output

Should The Fed Target Asset Prices

Big debate in macroeconomics– Some feel they should be included in a Taylor-like

rule.– Others strongly oppose

The Fed can passively affect asset prices by concentrating on low, stable inflation which will increase consumer confidence and, consequently, asset prices

Should The Fed Target Asset Prices

Some believe monetary policy should be used to prevent asset price bubbles from getting out of hand

– Austrian BIS view Bubbles can happen when the Fed passively allows credit to

expand Believe that unless a bubble is defused, a crash will follow. View tends to equate rising asset price with inflation, which

isn’t always the case

Is boom caused by realistic future earnings growth or “irrational exuberance”

Popping Asset Price Bubbles

Some disagree that asset price bubbles should be popped– Frederick Mishkin feels it is difficult for the Fed to

know when one is occurring and that they can no more info in this regard than the general public

If the general public already knows a bubble is occurring, it will deflate naturally

If the Fed misinterprets that a bubble has occurred, this will depress the economy

Popping Asset Price Bubbles

– Targeting stock prices could make the Fed look foolish

Only a weak link between monetary policy and the stock market

Thus, stock market could go into a different direction than monetary policy predicts, which could make the Fed look inept

Plan

Determine relationship between monetary policy and the stock market– Charts– Regression

Monetary policy measured by effective federal funds rate

Stock market measured by inflation-adjusted S&P 500 index values

Data

Ranged from July 1, 1954 – November 1, 2005 Monthly-basis Variables

– Effective federal funds rate– S&P 500 index values– Consumer Price Index (CPI)

Analysis

S&P 500 data was adjusted for inflation using the following formula:

Value for previous time in today’s dollars=

(Today’s CPI/Previous Time Period’s CPI) * Previous Time Period’s Dollar

Adjusts “yesterday’s” index to “today’s” dollar using CPI of each time period.

% Change of Effective Federal Funds Rate Vs. % Change of Inflation-Adjusted S&P 500January 1990 - November 2005

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

% Change of Effective Federal Funds Rate % Change of Inflation-adjusted S&P 500

Effective Federal Funds Rate vs. S&P500 Inflation-Adjusted Index

0

200

400

600

800

1000

1200

1400

1600

1800

2000

0.00 5.00 10.00 15.00 20.00 25.00

Eff ective Federal Funds Rate

Regression Equation

Y=S&P 500 inflation-adjusted index– Lagged so that the effective federal funds rate in

the past month is compared to the S&P 500 index in the current month

X=effective federal funds rate Produced significant, but weak results

– Adjusted R2 = 9.2%S&P inflation-adjusted index=787.04 – 32.79 * (effective federal funds rate)

Regression with 1-month lag

x=effective federal funds rate

y=inflation-adjusted S&P 500 index with 1-month lag

Regression Statistics

Multiple R 0.304991

R Square 0.09302

Adjusted R Square 0.091545

Standard Error 343.9662

Observations 617

ANOVA

df SS MS F Significance F

Regression 1 7462471 7462471 63.07412 9.5E-15

Residual 615 72762320 118312.7

Total 616 80224791

Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%

Intercept 787.0424 27.4966 28.62326 3.5E-115 733.0437 841.041 733.0437 841.041

X Variable 1 -32.7874 4.128391 -7.94192 9.5E-15 -40.8948 -24.6799 -40.8948 -24.6799

Regression Equation – Logarithm

James B. Bullard and Eric Schaling – Effective Federal Funds Rate=ln(Equity Prices)

Y=ln(S&P 500 inflation-adjusted index) X=effective federal funds rate Produced significant, but weak results

– Adjusted R2 = 13.1%ln(S&P inflation-adjusted index) = 6.57 – 0.055 * (effective federal funds rate)

Regression with 1-month lag and ln

x=effective federal funds rate

y=ln(inflation-adjusted S&P 500 index with 1-month lag)

Regression Statistics

Multiple R 0.364464

R Square 0.132834

Adjusted R Square 0.131424

Standard Error 0.469444

Observations 617

ANOVA

df SS MS F Significance F

Regression 1 20.76106 20.76106 94.20678 8.08E-21

Residual 615 135.5322 0.220378

Total 616 156.2932

Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%

Intercept 6.567831 0.037527 175.0149 0 6.494134 6.641528 6.494134 6.641528

X Variable 1 -0.05469 0.005634 -9.70602 8.08E-21 -0.06575 -0.04362 -0.06575 -0.04362

Conclusions

Weak relationship Many variables affect S&P 500

– Should not target stock market– Should not be used to pop asset price bubbles

No more information than the public Could appear foolish

Should stick with targeting low, stable inflation