The (In)Stability of Stock Returns and Monetary Policy Interdependence in the US

Abstract

We investigate the effects of monetary policy on equity returns and vice-versa in the US before, during and after the effective lower bound period (ELB) on interest rates. We use a novel inferential method in a (structural) VAR framework that exploits shifts in the volatility of shocks that affect equity returns and interest rates. Those shifts allow us to disentangle both effects without imposing restrictive assumptions  previously used in the literature. We find dramatic changes in the relationship between monetary policy and equity returns over the period. Before the ELB period, policymakers reacted to increases in stock returns by raising the interest rate. This reaction becomes negative or muted since the ELB period. Regarding the stock market response to monetary policy, we find that an expansionary  monetary policy increases equity returns before the ELB period. Since then, however, we estimate a negative response of equity prices to a monetary expansion, even after the ELB period.

Keywords: Monetary Policy, Stock Market, Fed Put, Parameter Instability, Structural Break