The Relationship Between the Federal Fund Rates and the Stock Market Alejandro Duarte ECO6226

6/22/06 Currently On June 28 and 29, the FOMC.  it is almost certain that the Fed will raise its short term rate to 5.25% (17th consecutive rate hike in the past two years) On June 5, Ben Bernanke, “inflation is at the high end of the Fed comfort zones.”  Expected by the end of the year, 5.50%. Economist:  Slowing down in the economy  Snow ball effect could take place  Recommendation to wait for more interest rates hikes

6/22/06 History The unexpected 50 basis points rate reduction in January 3 and April 18, 2001 produce a return in the stock market of 5.3% and 4.0% respectively. On February 5, 1994, the New York Times reported, after the Fed had tightened the monetary policy, that the Dow Jones Industrial Average had drop 96 points making the largest drop since November 15, This drop was the eighth biggest daily drop ever. On May 10, 2006 Federal Fund Rate was raised by 25 basis points to 5.00 percent. The S&P 500 decrease by a 1.28% change from the previous day’s closing.

6/22/06 Literature Patelis Patelis (1997) concluded that there are short terms and long term monetary policy variables which are significant predictors of future stock returns. Pointed out that monetary policy influences asset returns through dividend growth, real interest rates, and excess stock returns. Bernanke and Kuttner Bernanke and Kuttner (2005) presented strong evidence that the stock market is greatly negatively impacted when unanticipated monetary policy actions occurs. Sustained that when the monetary policy is anticipated, the impact is less dramatic and in the long run the stock market recuperates much faster. William Thorbecke William Thorbecke (1997) explained that in the short run, monetary policy has a real and quantitatively important effect on the stock returns. His study explained how changes in the monetary policy have larger effects on small companies over larger companies.

6/22/06 Plan of Action Understand the impact of the FFR to the stock market on two very distinctive periods:  First period, January 1, 1978 through December 31, 1982, in which the monetary policy – money supply and the non-borrowed reserves.  The second period, June 1, 2001 through May 31, 2006, in which the monetary policy – short term interest rate. Linear regressions were conducted for each period in the study with three main variables:  Stock market: monthly percentage change of the S&P 500 and Dow Jones Industrial Average  Monthly percentage change of the Federal Fund Rate.  Monthly percentage change of the inflation rate.

6/22/06 Period I - Regressions S&P = – FFR – Inflation (0.058) (0.102) t = n = 60 (adj)R 2 = DJIA = – FFR – Inflation (0.055) (0.096) t = n = 60 (adj)R2 = 0.097

6/22/06 Period I

6/22/06 Before 1994, the Fed very rarely provided information in advance in regards to how the monetary policy was going to change. FFR created a lot of uncertainty for investors which turn, at least in the short run, impacted the performance of the stock market. According to Bernanke and Kuttner (2005), on average, an unanticipated 25 basis point cut in the FFR target is associated with about 1% increase in broad stock returns. But an unanticipated 25 basis point hike is capable of producing stronger effects. The period had two recessions:  First part of  Thorbecke (1997) points out, the tight monetary policy during 1981 and 1982 recession impacted both small and large companies. As the Fed eases the monetary policy, the large companies were able to see the benefits rather than small companies. The SP& 500 ended the period with a 57.5% return over the 5 years. The Dow Jones Industrial Average ended the period with a 35.9% of gain. Period I - Explanation

6/22/06 Period I

6/22/06 Period I

6/22/06 S&P = 1.01 – FFR – Inflation (0.065) (0.032) t = n = 60 (adj)R2 = DJIA = – FFR – Inflation (0.069) (0.033) t = n = 60 (adj)R2 = Period II - Regressions

6/22/06 Period II

6/22/06 During this period, the Fed had made a point of announcing and preparing the country for any changes in the monetary policy. This allowed for the elimination of uncertainty. The economy suffered a strong recession after September 11, The economy attempted to bounce back; however, capita spending and job growth remained weak. As a response to the recession, the Fed decided to cut the FFR in November 2002 and June 2003 by.25 basis points in order to motivate faster recovery. By mid 2004, the economy was growing and the Fed decided to hike the interest rate by.25 basis points for 16 consecutive hikes. The S&P 500 ended the period with a 3.73% return. and the DJIA with a 6.34% return. Period II - Explanation

6/22/06 Period II

6/22/06 Period II

6/22/06 Conclusion FFR has a significant impact on the performance of the stock market; however, the level of significance varies depending on the periods.  First period, the restrained used by the Fed in not announcing in advance the changes in the monetary policy along with a strong recession, provided significant evidence of the dependency that the stock market had over the FFR.  Second period, it was clear that the relationship between the variables where not as strong as in the first period, but the relationship was significant. The inflation rate was much smaller than in the first period, but it presented higher volatility with a weaker relationship to the stock market. Smaller firms tend to experience a bigger impact on negative monetary policy, as oppose to the large firms which usually are well funded with collateral and immune from credit constraints. Understanding how the FFR could impact the performance of the stock market, it is explained by Patelis (1997). Patelis points out a set of theories that explained the power that the monetary policy has over the performance of the stocks:  financial propagation mechanism (developed by Fazzari, Hubbard, and Peterson, 1988)  Credit channel of monetary policy transmission (developed by Bernanke and Gertler, 1989)

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