Monetary Policy and Mispricing in Stock Markets

51 Pages Posted: 7 Sep 2016

See all articles by Benjamin Beckers

Benjamin Beckers

German Institute for Economic Research (DIW Berlin)

Kerstin Bernoth

German Institute for Economic Research (DIW Berlin)

Date Written: August 2016

Abstract

This paper investigates whether central banks can attenuate excessive mispricing in stocks as suggested by the proponents of a "leaning against the wind" (LATW) monetary policy. For this, we decompose stock prices into a fundamental component, a risk premium, and a mispricing component. We argue that mispricing can arise for two reasons: (i) from false subjective expectations of investors about future fundamentals and equity premia; and (ii) from the inherent indeterminacy in asset pricing in line with rational bubbles. We show that the response of the excessive stock price component to a monetary policy shock is ambiguous in both the short- and long-run, and depends on the nature of the mispricing. Subsequently, we evaluate the scope for a LATW policy empirically by employing a time-varying coefficient VAR with a flexible identification scheme based on impact and long-run restrictions using data for the S&P500 index from 1962Q1 to 2014Q4. We find that a contractionary monetary policy shock in fact lowers stock prices beyond what is implied by the response of their underlying fundamentals.

Keywords: Asset pricing, bubbles, financial stability, leaning against the wind, mispricing, monetary policy, time-varying coefficient VAR, zero and sign restrictions

JEL Classification: E44, E58, E52, G12, G14

Suggested Citation

Beckers, Benjamin and Bernoth, Kerstin, Monetary Policy and Mispricing in Stock Markets (August 2016). DIW Berlin Discussion Paper No. 1605. Available at SSRN: https://ssrn.com/abstract=2835491 or http://dx.doi.org/10.2139/ssrn.2835491

Benjamin Beckers (Contact Author)

German Institute for Economic Research (DIW Berlin) ( email )

Mohrenstraße 58
Berlin, 10117
Germany

Kerstin Bernoth

German Institute for Economic Research (DIW Berlin) ( email )

Mohrenstraße 58
Berlin, 10117
Germany

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