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

2. 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

3. 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

4. ↑ 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

5. ↑ 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

6. 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

7. 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

8. 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”

9. 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

10. 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

11. 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

12. 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)

13. 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.

16. 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= – * (effective federal funds rate)

17. Regression with 1-month lag

18. 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 – * (effective federal funds rate)

19. Regression with 1-month lag and ln

20. 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