The Asset Price Transmission Mechanism - The Affect Of The Federal Funds Rate On Asset Prices Elizabeth Gonzalez.

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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 Firm’s balance sheet effects 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

↑ Money Supply  ↑ Stock Prices  ↑ Consumers’ Financial Assets  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

↑ Money Supply  ↑ Housing Prices  ↑ Housing Expenditures  ↑ 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)

Value for previous time in today’s dollars= 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.

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

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

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