MONETARY POLICY AND THE U.S. STOCK MARKET

Transcription

1 MONETARY POLICY AND THE U.S. STOCK MARKET Marc D. Hayford and A. G. Malliaris * Deparmen of Economics Loyola Universiy Chicago Revised draf: June 8, 00 Absrac Does he Federal Reserve Sysem consider he level of he sock marke when seing moneary policy? This paper examines empirically if moneary policy, since he Ocober 9, 987 sock marke crash, has been influenced by he sock marke. We conclude ha he Fed considers he sock marke only o he exen ha i influences inflaion and he oupu gap. As a consequence he Federal Reserve policy accommodaed he high valuaions in he 990s of he sock marke as measured by he S&P500 P/E raio. (JEL Classificaion: E50, G0, Key Words: moneary policy, sock marke, Federal funds rae, Taylor s rule, bubbles) * Corresponding auhor: A. G. Malliaris, Deparmen of Economics, Loyola Universiy Chicago, 80 Norh Michigan Avenue, Chicago, Illinois 606 USA; mallia@luc.edu Phone: () ; Fax: () Acknowledgemen: An earlier version of his paper was presened a an economics seminar a he Universiy of Norhern Illinois, a he Brown Bag Macroeconomics Seminar of he Federal Reserve Bank of Chicago, and a he European Financial Managemen Associaion Meeings in Lugano, Swizerland. We are graeful o he seminar and conference paricipans for heir numerous helpful suggesions. We are especially hankful o Philip Barholomew, Elijah Brewer, Marsha Courchane, Charles Evans, Lars Hansen, George Kaufman, James Moser and Francois Velde for heir valuable commens ha helped us improve our work. All remaining errors are our own responsibiliy. 0

2 MONETARY POLICY AND THE U.S. STOCK MARKET. Inroducion The moneary policy goals of he Federal Reserve Sysem, as ofen saed in publicaions and esimony of Fed officials, are price sabiliy and susainable economic growh. Recenly he Fed officials and academic economiss have addressed he quesion of wheher in addiion o price level sabiliy, a cenral bank should also consider he sabiliy of asses prices. As Greenspan, in his December 5, 996 Lecure o he American Enerprise Insiue for Public Policy Research, says " where do we draw he line on wha prices maer? Cerainly prices of goods and services now being produced--our basic measure of inflaion-- maer. Bu wha abou fuures prices or more imporanly prices of claims on fuure goods and services, like equiies, real esae, or oher earning asses? Is sabiliy of hese prices essenial o he sabiliy of he economy?" Chairman Greenspan, answers his own quesion in he form of boh reflecions and addiional quesions: "Bu how do we know when irraional exuberance has unduly escalaed asse values, which hen become subjec o unexpeced and prolonged conracions as hey have in Japan over he pas decade? And how do we facor ha assessmen ino moneary policy? Perhaps parly in response o hese saemens by Greenspan, he academic lieraure has addressed boh he normaive quesion should moneary policy reac o asse bubbles? as well as he posiive quesion does moneary policy reac o asse bubbles?. Afer a review of he academic lieraure in secion, his paper focuses on he posiive quesion of wheher moneary policy since 987 has been influenced by he high

3 valuaion of he sock marke. Numerous saemens made by Chairman Greenspan indicae ha he believes ha soaring sock prices may creae imbalances in he economy ha hreaen he goals of general price level sabiliy and susainable economic growh. I is naural o ask: Have hese concerns by he Chairman been acivaed ino moneary policy decisions?. Review of he Lieraure How should moneary policy reac o a sock marke bubble? Using he language of conrol heory we can ask he more echnical quesion: should moneary policy arge he level of equiy prices, measured by an index such as he S&P 500 Index? Mos economiss consider hese normaive quesions as meaningless because here is lile agreemen on how o recognize a bubble ex ane. Defining a bubble as he difference beween he acual marke price and he fundamenal price is a relaive saemen ha becomes operaional provided one could compue he fundamenal price. If he fundamenal price canno be compued, hen one canno alk abou he exisence and he magniude of he bubble. Shiller (989) and, more recenly Sagle (997), offer an exensive review of he lieraure on marke volailiy and discuss boh he heoreical and empirical issues associaed wih bubbles. A he risk of oversimplificaion, one finding of his lieraure is ha bubbles are easier o idenify ex pos raher han ex ane. For example, i is difficul o find economiss who would argue oday ha he sock marke increase in Japan in he lae 980s or he Nasdaq increase in he lae 990s refleced only fundamenals. The fac ha in boh cases hese markes declined significanly is ex pos evidence of he exisence of a bubble, ye here was no consensus among economiss prior o is dramaic collapse ha a bubble was presen in hese wo markes.

4 If we canno ascerain he exisence of a bubble, how can we decide wha should he reacion of he moneary policy be in regard o i? One way o simplify he analysis is o follow Blanchard (000) who, for he sake of argumen, assumes ha he cenral bank knows ha here is a bubble in he sock marke. In oher words, suppose ha he Fed has decided ha he price of socks, measured by some index, exceeds fundamenals and also assume ha his bubble will evenually collapse and sock prices will reurn o fundamenals. How moneary policy ough o respond under hese assumpions? Economiss have proposed wo answers. One group, represened by Bernanke and Gerler (999, 00) argues ha moneary policy ha arges he rae of inflaion is bes, independen of wheher a bubble exiss or no. Pu differenly, he exisence of a bubble should no cause he cenral bank o change is policy of argeing inflaion. Anoher group represened by Cecchei (998) argues ha he cenral bank can improve economic performance by paying aenion o asse prices. Nex, we presen a brief elaboraion of hese argumens. Bernanke and Gerler (999) argue ha a cenral bank dedicaed o a policy of flexible inflaion argeing should pay lile aenion o asse inflaion because a proper seing of ineres raes o achieve he desired inflaion arge will also sabilize asse prices. The auhors (999, p.8) view price sabiliy and financial sabiliy as highly complemenary and muually consisen objecives o be pursued wihin a unified policy framework. Elsewhere hey (999, p.8) sae he []rying o sabilize asse prices per se is problemaic for a variey of reasons, no he leas of which is ha i is nearly impossible o know for sure wheher a given change in asse values resuls from fundamenal facors, nonfundamenal facors, or boh.

5 The sufficiency of argeing inflaion can be argued as follows. Keeping boh curren and expeced inflaion a a consan level is equivalen o mainaining oupu a is naural level. The exisence of a bubble can eiher cause no change in aggregae demand or cause i o increase because of he wealh effec or some oher reason. In eiher case, he moneary rule of inflaion argeing guides he cenral bank o ac appropriaely, eiher by doing nohing in he case he bubble causes no change in aggregae demand or by ighening in he case he bubble increases aggregae demand via he wealh effec. Blanchard (000) finds he argumens of Bernanke and Gerler powerful bu also argues ha heir model works provided he bubble affecs some componens of spending more han ohers. For example, if he bubble increases consumpion, via he wealh effec, ha pus pressure on inflaion, and Fed ighening guided by inflaion argeing can be opimal. Wha if he bubble causes publicly raded firms whose equiy has increased because of he bubble o increase heir invesmen? If invesmen depends on he bubble, among oher economic facors, hen wih oupu a is naural level, an increase in invesmen can occur only by an equivalen decrease in consumpion. Thus, while inflaion argeing keeps inflaion consan, he composiion of oupu ils more in favor of invesmen and hus he bubble may cause excessive capial accumulaion. When ulimaely he bubble burss his excessive capial accumulaion deers firms from invesmen and pospones economic growh. Thus inflaion argeing does no address issues relaed o he impac of a bubble on he composiion of oupu and he long-run impac of he bubble on capial accumulaion and growh. Ohers who have also evaluaed he model of Bernanke and Gerler (999) are Bordo and Jeanne (00) who have argued ha asse price reversals can be very cosly in erms 4

6 of declining oupu, such as he cases of he US in he early 90s or of Japan during he 990s. They go furher o argue ha radiional moneary policy may be unable o correc such asse price disurbances and herefore moneary policy should aemp, primarily, o discourage he emergence and growh of bubbles, raher han ac afer hey burs in an effor o sabilize he economy. Mishkin (000) also acknowledges ha he mos serious economic downurns are ofen associaed wih financial insabiliy bu does no discuss specifically he impac of a sock marke crash on he economy. The implicaion of Mishkin s argumen is ha moneary policy should aemp o avoid financial insabiliies such as he 99 US sock marke crash or he Japanese sock marke decline of he 990s. However, Cogley (999) argues ha deliberae aemps o puncure asse price bubbles may desabilize he economy and hus moneary policy may generae insabiliies ha are similar o he ones arising from he burs of a bubble. Bullard and Schaling (00) use a simple macroeconomic model o sudy he implicaions of argeing inflaion, oupu and equiy prices. They show ha such a policy ha reacs o equiy price increases can be counerproducive because i can inerfere wih he policy maker s abiliy o minimize inflaion and oupu variabiliy. They also show ha under cerain condiions, a policy of argeing sock marke prices can lead o an indeerminae raional expecaions equilibrium and hence a more unpredicable volailiy han would be achieved if asse prices were ignored. They conclude ha argeing he sock marke degrades he effeciveness of moneary policy and can do real damage when such damage is no possible by concenraing on inflaion and oupu argeing. Thus, moneary policy should ignore he sock marke. 5

7 Goodfriend (00) reaches a similar conclusion. He argues ha he direcion and size of he uncondiional correlaion beween asse price movemens and real shor-erm ineres raes is no sable. Thus, in principle, he appropriae direcion and size of he ineres rae response o equiy prices would be difficul o discern in pracice. Finally, Filardo (000, 00) also explores he role of moneary policy in an economy wih asse bubbles by developing a small-scale macroeconomic model and running various simulaions. He finds ha if here is no uncerainy abou he role of asse prices in deermining oupu and inflaion hen moneary policy should respond o asse prices. However, if he moneary auhoriy is sufficienly uncerain abou he macroeconomic consequences of sock prices hen i is preferable for moneary policy o remain neural. In conras o Bernanke and Geler and he oher auhors who recommend ha moneary policy should no respond o sock marke bubbles, Cecchei (998) argues ha moneary policy should ake ino accoun asse prices. The logic behind his argumen is he idea ha he policymaker mus ofen rade off variabiliy in oupu for variabiliy in prices because i is generally no possible o sabilize boh. More specifically, Cecchei, Genberg, Lipsky and Wadhwami (000) argue ha cenral bankers can improve economic performance by paying aenion o asse prices. Cecchei and Krause (000) examine in deail he connecion beween he dramaic changes in he financial srucure (a concep much more general han sable asse prices) of numerous counries and conclude ha hese changes conribued o he sabiliy of boh economic growh and low inflaion. In a recen paper, Cecchei, Genberg and Wadhwani (00) revisi he same quesion and argue ha here are sound heoreical reasons for an inflaion argeing moneary 6

8 policy o improve he economy s performance by reacing o asse price misalignmens. They emphasize ha policy reacions o sock price bubbles mus be qualiaively differen from reacions o sock price increases driven by fundamenals, such as increases in produciviy and earnings. The concern wih sock marke bubbles is boh heir ineviable collapse bu also he encouragemen of overinvesmen and excessive borrowing by households and firms before he bubble collapse. Thus, bubbles can cause, boh during heir rapid growh and also afer heir collapse, serious economic imbalances ha can cause eiher inflaion or deflaion. One reason ha Cecchei and his coauhors suppor he opposie conclusion han he oher auhors is because hey explore a larger family of policy reacion funcions. Wha is he enaive answer o he normaive quesion: should moneary policy reac o an asse bubble? The answer depends on he iming of he bubble. Afer he bubble burss, moneary policy should always ac in order o sabilize he economy. Before he collapse of he asse bubble, i is difficul o argue wha moneary policy should do because i is no clear how o deermine a bubble and esimae is size. If he Fed believes ha here is a bubble and is size is rapidly growing, hen he Fed should ac o reduce i. If he Fed is uncerain abou he exisence of a bubble, i is hard o argue ha i should change is inflaion argeing. Nex, we move on from he normaive o he posiive quesion: wha does moneary policy do in response o asse prices. Tarhan (995) finds evidence ha he Fed affecs asse prices. Filardo (000) reviews carefully he lieraure on including asse prices in inflaion measures and finds lile evidence ha paying aenion by he Fed o asse prices would reliably improve economic sabiliy. Fair (000) uses a macroeconomic model o 7

9 offer quaniaive evidence of he Bordo and Jeanne (00) claim ha he Fed may be unable o correc asse price disurbances. Fair shows ha he negaive effecs from he loss of wealh following a sock marke crash dominae he posiive effecs from he Fed lowering ineres raes immediaely afer such a crash. Rigobon and Brian (00) use an idenificaion echnique based on he heeroskedasiciy of sock marke reurns o idenify he reacion of moneary policy o he sock marke. They find ha moneary policy reacs significanly o sock marke movemens, wih a 5% rise (fall) in he S&P 500 Index increasing he likelihood of a 5 basis poin ighening (easing) by abou half. The auhors decompose boh daily and weekly movemens in ineres raes and sock prices from approximaely 985 o 999. Their resuls sugges ha sock marke movemens have a significan impac on shorerm ineres raes, driving hem in he same direcion as he change in sock prices. The auhors aribue his response o he anicipaed reacion of moneary policy o sock marke increases. They acknowledge ha his inerpreaion should be aken a bi cauiously. Hayford and Malliaris (00) also empirically invesigae how he Fed has responded o sock prices using quarerly daa and conclude ha he Fed was no bubbleneural. In conras o he above lieraure, his paper akes four approaches o answering he posiive quesion: has moneary policy during he Greenspan Fed been sock marke neural? Our firs approach is jus o compare, for he period 987 o 00, he changes in he Federal funds rae wih he behavior of measures of sock marke valuaion, unemploymen, GDP gaps and inflaion. The second approach is a review of he minues of he FOMC meeings. This is he closes we can come o direcly asking he FOMC 8

10 members if he sock marke influences heir decision wih respec o he arge for he Federal funds rae and how. Our hird approach is o esimae Taylor s Rule (Taylor 99) augmened wih wo alernaive measures of sock marke valuaion. Finally we esimae a VAR model o address he quesion of wheher he Fed se he Federal funds rae in response o he sock marke.. Measures of Sock Marke Valuaion In addressing he quesion of wheher moneary policy has responded o he sock marke, we use wo relaed measures of sock marke overvaluaion for he S&P 500: he P/E raio and he implied equiy premium. The P/E is he more commonly used measure. A P/E raio is above is hisoric average is ofen used o signal a poenial overvaluaion. Shen (000) finds srong hisorical evidence ha disappoining sock marke performance follow high price-earnings raios. The calculaion of implied equiy premium follows from he Gordon Equaion (Gordon 96) for sock marke valuaion. Sock prices are assumed o be he expeced presen value of fuure earnings discouned a he long-erm governmen bond rae plus an equiy premium. Assuming ha nominal earnings are expeced o grow a he curren growh rae g, ha he nominal long-erm governmen bond rae and he equiy premium are consan, hen he sock price is given as P ( + g ) E = i + ρ g where P is he sock price, E is earnings, and g is he growh rae of earnings. Solving for he implied equiy premium resuls in ρ = + E ( g) i + g P 9

11 or in real erms E ρ = P ( + rg )( + π ) i + rg + π + rg π To calculae he implied equiy premium (following he World Economic Oulook, April 000) we use he growh rae of poenial real GDP for rg, recen inflaion for π, he inverse of he SP 500 price earnings rae for E/P and he en-year consan mauriy Treasury bond rae for i. Figure 40 Panel A p/e raio S&P Panel B Implied Equiy Premium percen Figure compares he wo measures of marke valuaion from 987: o 00:4. The mean for he S&P 500 P/E raio for he period 948 o 99 is abou 4. Hence by hisoric sandards, a P/E raio in excess of 4 would indicae a poenially overvalued marke. The hisoric average of he implied equiy premium from 960 o 99 is 8%. An equiy premium below his value could signal overvaluaion. Boh measures he sock marke was overvalued prior o he 987 crash. Furher boh measures agree ha from 996 o 00 he marke was overvalued. 0

12 4. Sock marke valuaions, he unemploymen rae, inflaion, GDP gaps and he Federal funds rae. In his secion we make he prima facie case ha he Fed has ended o accommodae sock marke overvaluaion since 987. This observaion is consisen wih he Fed having a primary goal of price sabiliy excluding asse prices. Figure gives he graphs of he major economic indicaors from 987 o 00. As measured by he nominal Federal funds rae (see panel A), here are hree periods of moneary ighening in he sample period. The firs is from March 0, 988 o May 7, 989. Boh measures of sock marke valuaion presened in figure sugges he sock marke was more or less appropriaely valued in his period. This suggess he Fed mus have ighened for some reason oher han he sock marke. Panel B shows ha GDP deflaor/inflaion was increasing, panel C ha unemploymen was below he Gordon (000) esimaes of he naural rae and panel D shows ha oupu was above poenial, using he CBO year 00 esimaes of poenial GDP in This suggess ha he Fed ighened due o concerns abou poenial acceleraing inflaion. The second period of ighening runs from February 4, 994 o February, 995. The daa sugges he Fed may have ighen o deflae a financial bubble since a he beginning of 994 he P/E raio was abou 0, while inflaion had been falling and was a %. In addiion, he unemploymen rae was above esimaes of is naural rae and he CBO oupu gap was negaive. The final period of ighening is he period from June 999 o December 000. Boh measures of sock marke valuaion sugges he marke was overvalued a he beginning of he ighening period. In addiion, while inflaion was subdued, measures of excess demand, such as he gap beween he naural and acual unemploymen rae and he GDP gap all indicaed subsanial excess demand. While he

13 FOMC may have moved o ighen due o he sock marke, i is perhaps more plausible ha he Fed was aemping o preemp inflaionary pressure. There are hree periods since Ocober 987 where he Fed has been easing or holding he nominal Federal funds rae consan. The firs, from June 6, 989 o 99, raes were falling and hen were consan for all of 99. During his period he P/E has an upward rend, saring a and ending a almos and he equiy premium is falling. The second period of ease or relaively consan Federal funds raes sars on July 6, 995 and runs unil June 0, 999 wih one increase on March 5, 997. During his period he P/E raio rose from 7 o over 0 and he equiy premium has a downward rend. Chairman Greenspan s commens sugges ha he was concerned abou he sock marke by he end of December 996. Figure # 0 Panel A: Federal Funds Rae 4.5 Panel B GDP Deflaor Inflaion Panel C Unemploymen: Acual and Gordon's Naural Panel D CBO GDP Gap (Revised 00 esimae) 7 6 naural acual

14 The hird period of moneary ease begins January 00. Since he sock marke begins is fall in March 000 he iming suggess he Fed was responding o he economic slowdown eviden in he decrease in he oupu gap and he rise in he unemploymen rae. Of course, he economic slowdown may have been due in par o he fall in he sock marke. In summary, he firs wo periods of moneary ease arguably helped o faciliae an increase in sock marke valuaion and provide a prima facie case ha in hese periods he Fed has accommodaed he poenial overvaluaion of he sock marke. The hird period of moneary ease follows a decline in he sock marke bu presumably was reacing o he slowdown in he real economy. Of he hree periods of rising Federal funds raes, only he 994 moneary ighening is a possible candidae for an increase in he Federal funds rae being a direc response o an overvalued sock marke. 5. Evidence from FOMC minues The minues of he FOMC meeings are available six weeks afer each meeing. The minues clearly show ha someimes he Fed does consider he sock marke when deermining he sance of moneary policy. For example, he minues of he FOMC meeing on November, 987, he firs meeing afer he Ocober 987 sock marke crash, documen he fac ha he Fed increased bank reserves in response o he decline in he sock marke. The concern of he members of he FOMC was he fragiliy of financial markes in he wake of he crash and he poenial negaive wealh effec on aggregae demand. From 988 o Sepember 99 he minues show lile discussion of he sock marke oher han o menion wha happened o sock prices in he iner-meeing periods. For 99 o January 00, Table provides a rough summary of menions of he sock marke in he FOMC minues from 99 o January 00. The second column of Table

15 gives he number of meeings a which FOMC members expressed concern he poenial overvaluaion of he sock marke. For example in 996 in 4 ou of 8 meeings members expressed such a concern which consisen wih Chairman Greenspan giving his irraional exuberance speech in December 996. The hird column gives he number of meeings where he FOMC minues menion he sock marke in conex of is wealh effec on consumpion and/or is effec on he cos of capial. From 998 o 000 he sock marke wealh effec was menioned in he minues of every meeing. The las column in able gives he number of meeings where he minues menion concern abou he reacion of he sock marke o moneary policy. A careful reading of he minues suggess ha he cenral goal of moneary policy is price sabiliy and susainable economic growh. Furher he minues sugges ha he sock marke is considered o he exen ha members of he FOMC feel he behavior of he sock marke may influence aggregae demand and hence oupu and inflaion. Consisen wih a recen speech by Federal Reserve Board Governor Gramlich (00), here is no evidence from he minues ha he FOMC has an implici arge for he sock marke independen of he FOMC goals for inflaion and growh. However he FOMC minues sugges ha moneary policy may respond o he sock marke indirecly hrough he wealh effec of he sock marke on aggregae demand. Table : Summary of discussion of sock marke in FOMC meeing Year Concern abou value of sock marke or possible correcion Concern or discussion of effec of sock marke on aggregae Concern or discussion of sock marke as a consrain on moneary policy demand

16 The Taylor Rule Evidence To esimae wheher has moneary policy sysemaically responded o he sock marke, we augmen Taylor s (99) moneary policy rule wih a arge for he sock marke: * * * () i = π + r + α ( π π ) + α y + α ( ρ ρ ) where i denoes he curren nominal Federal funds rae, π is he average inflaion rae, π * is he arge inflaion rae, r * is he long run equilibrium real Federal funds rae, y is he oupu gap, and ρ is a measure of sock marke valuaion and ρ * is is arge value. The Taylor moneary policy rule implies ha he Fed ses he Federal funds rae o hi a arge inflaion rae and a arge for real GDP ha equals poenial GDP. Moneary policy is sable, i.e. offses increases in inflaion by increasing he real Federal funds rae if α > 0. If moneary policy is also se o sysemaically influence he sock marke, he Fed would aemp se ρ equal o ρ *. If ρ is he price earnings raio and i is above is arge value, a moneary policy aimed a reducing he esimaed bubble would involve increasing he Federal funds rae, so α > 0. However, if moneary policy is conribuing o a sock marke bubble hen, α < 0. If insead ρ is implied equiy premium (o be defined below) and i is below is arge value, a moneary policy aimed a reducing he esimaed bubble would involve decreasing he Federal funds rae, so α < 0. However, if moneary policy is accommodaing a sock marke bubble, hen α > 0. 5

17 Following Taylor (99) we use quarerly daa o esimae equaion (). To measure excess demand, Taylor uses he Hodrick- Presco filer and revised daa for real GDP o calculae he GDP gap as he percen deviaion of real GDP from he Hodrick- Presco measure of poenial GDP. Orphanides (000) argues ha using real ime esimaes of poenial GDP ha were available a he ime he FOMC me is more appropriae and ha doing so reduces he explanaory power of Taylor s rule. Evans (998) argues ha using he gap beween unemploymen and an esimae of he naural rae of unemploymen comes closer o real ime daa han using revised values of real GDP. A deailed evaluaion of Taylor's rule is presened in Benhabib, Schmi-Grohe and Uribe (998), Kozicki (999) and Hezel (000). In his paper we use wo alernaive measures of excess demand: he CBO s esimae of he real GDP gap and he deviaion of NAIRU from he acual unemploymen rae. Inflaion is measured as he growh rae of he GDP deflaor from he same quarer of he previous year. Table : Variable Definiions and sample saisics Fedfunds = Federal funds rae Inflaion = Growh in he GDP deflaor, year over year CBOGAP = CBO esimae of GDP gap, using daa available in year 000 UNEMGAP = Gordon s (000) esimae of NAIRU minus acual unemploymen rae. P/E = S&P 500 price earnings raio PREMIUM = implied equiy premium on he S&P 500 Sample period: 987: o 00:4 mean Sd. Dev Max Min Fedfunds Inflaion CBOGAP UNEMPGAP P/E PREMIUM

18 Esimaing equaion (), boh wih and wihou he measures of sock marke valuaion, resuls in serially correlaed errors. This does no seem o boher Taylor (999). Oher researchers (e.g. Evans (998), Judd and Rudebusch (998) and Bernanke and Gerler (999)) use a dynamic specificaion of Taylor s rule o obain serially uncorrelaed errors. Below we repor esimaes of Taylor s rule wih boh saic and dynamic specificaions. 7. Saic Specificaions The economeric specificaion of equaion (), is as follows * () i = c + cπ + c y + c4ρ where c * * * = r απ α ρ c = + α if moneary policy is sable > c = α c 4 = α Table repors esimaes of equaion () for wo measures of excess demand and he wo measures of sock marke valuaion. All coefficiens are saisically significan a he usual significance levels. and repored in columns and of Table repor he esimaes of equaion () using CBOGAP and UNEMGAP as alernaive measures of excess demand wihou including a measure of sock marke valuaion. The esimaed parameers for inflaion and excess demand are consisen wih hose repored by Taylor (999). Moneary policy is found o be sable during his period, wih he Federal funds rae esimaed o increase by.5 percenage poins for every percenage poin increase in inflaion, if he CBOGAP is he measure of excess demand. If 7

19 UNEMGAP is used, he Federal funds rae is less responsive o inflaion bu moneary policy is sill esimaed o be sable over he period. Table : Saic Taylor rules, OLS esimaion Dependen Variable: Federal funds rae (mean = 5.64, sandard deviaion =.77) Sample: 987: o 00:4 (-saisics in parenhesis) Consan: c (7.7) (6.) (7.48) (5.) (9.9) (4.9) Inflaion: c (.4) (.6) (8.96) (8.7) (7.47) (7.4) Measure of excess demand: c CBOGAP (.89) (.7) (9.8) UNEMGAP -.47 (.) (6.5). (9.) Measure of sock marke valuaion: c 4 P/E (-4.0) (-7.0) PREMIUM (.09) (.4) R DW Figure shows he acual Federal funds rae and he prediced Federal funds rae from and. Using UNEMGAP as he measure of excess demand gives a slighly beer fi o he acual Federal funds rae. s o 6 in Table (columns 4 o 7) repor esimaes of equaion () using he wo measures of sock marke valuaion and he wo measures of excess demand. Consisenly here is negaive coefficien on he price earnings raio (P/E)and a posiive coefficien on he implied equiy premium (PREMIUM). Esimaed models and 5 imply ha an increase in he P/E raio of 6.9 (an approximaely sandard deviaion increase), resuls in a decrease in he Fed funds rae 8

20 by 48 o 69 basis poins. s 4 and 6 indicae ha a decrease in he implied equiy premium by. (an approximaely sandard deviaion decrease) resuls in a decrease in he Fed funds rae by abou 0 basis poins. The effecs seem o us o be large for he P/E raio. One inerpreaion of hese resuls is ha during he sample period, conrolling for inflaion and he GDP gap, he Fed was lowering he Federal funds rae as he marke became more overvalued. The inclusion of measures of sock marke valuaion in he saic Taylor rule in mos cases reduced he magniude of inflaion coefficien ( c ). 5, which uses UNEMPGAP as he measure of excess demand and P/E for he measure of sock marke overvaluaion, resuls in unsable moneary policy ha is c <. Obviously, boh P/E and 0 Figure : Saic Taylor Rules: versus acual PREMIUM depend on ineres raes hemselves, so perhaps he regression resuls reflec some simulaneiy bias. To address he problem of poenial simulaneiy bias, we esimaed equaion () using insrumenal variables (IV). As insrumens for he measures of sock marke overvaluaion we used zero o wo lags of he growh rae of real GDP from he previous 9

21 year. We use hese insrumens on wo grounds: (a) he lag beween changes in he Federal funds rae and oupu growh is long and variable and ypically saed by he Fed o be o 8 monhs. In addiion, over he sample period 987 o 00 he correlaion beween curren real GDP growh and he level of he Federal funds rae is This suggess ha he growh rae of curren and pas real GDP is uncorrelaed wih he curren level of he Federal funds rae. (b) Sock prices as marke paricipans discouned forecass of fuure earnings will be correlaed o curren real GDP growh if marke paricipans are forecasing he fuure based on wha hey observe in he presen. Empirically, curren real GDP growh is correlaed wih he measures of marke overvaluaion, 0., and 0.6 for P/E and PREMIUM respecively. On heoreical grounds we would expec earnings o be correlaed wih GDP growh. Table 4 shows he IV esimaes of equaion () wih he wo measures of excess demand and he wo measures of marke overvaluaion. Compared wih he OLS esimaes he inflaion coefficiens are larger and sill imply a sable moneary policy for of 4 regressions. The coefficien esimaes on he measures of excess demand show lile change. The dramaic differences are wih he coefficien esimaes on he measures of sock marke overvaluaion. Using curren and lagged oupu growh as insrumens, resuls in saisically insignifican esimaes in of 4 regressions. In addiion he magniude of he coefficiens are much smaller han he OLS esimaes for regressions using he CBOGAP as he measure of excess demand. Only model 5 gives resuls consisen wih and increase in he P/E resuling in a decrease in he Federal funds rae. To sum up he resuls of Table and 4, adding a measure of sock marke valuaion o he saic Taylor rule resuls in a negaive correlaion, alhough saisically weak for 0

22 he insrumenal variables regressions, beween he Federal funds rae and measures of sock marke overvaluaion afer conrolling for inflaion and measures of excess aggregae demand. Taken seriously, his resul indicaes ha he Greenspan moneary regime, raher han deflaing apparen speculaive bubbles, has a mos accommodaed hem. This is consisen wih he prima facie evidence presened in secion above. A his poin some readers migh be concerned abou he low Durban Wason saisic wih is implicaion ha he errors in he above regression equaions are serially correlaed. Following oher researchers (e.g. Judd and Rudebusch (998)) we address his issue by esimaing a dynamic Taylor rule. Table 4: Saic Taylor rules, IV esimaion Dependen Variable: Federal funds rae (mean = 5.64, sandard deviaion =.77) Sample: 987: o 00:4 (-saisics in parenhesis) Consan: c (.) (4.55) (5.94) (.54) Inflaion: c (8.8) (6.7) (6.4) (5.5) Measure of excess demand: c CBOGAP (.8) (8.4) UNEMGAP (5.7).4 (7.69) Measure of sock marke valuaion: c 4 P/E (-0.0) (-.77) PREMIUM (0.40) - 0. (.0) R DW Insrumens: Inflaion, CBOGAP (models and 4) UNEMGAP (models 5 and 6) Growh rae of real GDP from year ago (lags 0 o ).

23 8. Dynamic Taylor rule Specificaions Following Judd and Rudebusch (998) and including a arge for he sock marke, wrie he arge for he nominal Federal funds rae as: () ( ) ( ) * * * * ρ ρ α α π π α π = y r i wih he acual changes in he fed funds rae following: (4) ( ) * + = i i i i γ γ where γ measures he speed of adjusmen of he acual fed funds rae o he arge. Insananeous adjusmen would imply ha γ is infinie. Combining equaion () and (4) resuls in: ( ) ( ) [ ] * * * = i i y r i γ ρ ρ α α π π α π γ Resuling in he regression equaion: (5) [ ] = i c y c c c i c c i ρ π where: [ ] * * * ρ α α π γ = r c γ = c γ = c adjusmen parameer 4 α + = c > if moneary policy is sable. 5 α = c 6 α = c

24 Table 4 repors esimaes of equaion (5) for he wo measures of excess demand and he wo measures of sock marke overvaluaion. For hese models he Q-saisics sugges ha regression errors are serially uncorrelaed. Table 5: Dynamic Taylor rules, OLS esimaes Dependen Variable: Federal funds rae (mean =-0.08, sandard deviaion = 0.5)Sample: 987: o 00:4 (-saisics in parenhesis) Consan: c (.4) (.5) (5.68) (.86) (5.85) (.8) Fedfunds - : c 0.6 (6.) 0.7 (7.) 0.5 (.7) 0.6 (5.85) 0.9 (.76) 0.7 (6.66) Adjus. Param. c 0. (4.46) 0. (.6) 0.9 (6.) 0.4 (4.) 0. (5.98) 0. (.5) Inflaion: c (6.68) (5.08) (.7) (4.5) (.7) (.54) Measure of excess demand: c 5 CBOGAP (5.87) (8.7) (5.8) UNEMGAP -.7 (4.78) (9.66).6 (4.6) Measure of sock marke valuaion: c 6 P/E (-4.) (-4.9) PREMIUM (0.0) (0.0) R DW Q-saisic 4 lags (Prob) 7. (0.) 5.67 (0.). (0.68) 7. (0.) 5.48 (0.4) 5.65 (0.) 7 and 8 repored in columns and of Table 5 repor he esimae of equaion (5) using CBOGAP and UNEMGAP as alernaive measures of excess demand wihou including a measure of sock marke valuaion..

25 The resuls for 7 are similar o he saic in erms of he size of he parameers on inflaion and he CBOGAP. Using UNEMPGAP as he measure of excess demand resuls in a smaller response of he Federal funds rae o inflaion alhough moneary policy is sill sablefigure 4 shows he acual Federal funds rae and he prediced Federal funds rae from 7 and 8. The picure is very similar o ha of figure wih he dynamic models, which assume he Fed adjuss he Federal funds rae gradually o he desired argeed value, predicing as one would expec, a smooher pah for he Federal funds rae. s 9 o (columns 4 o 7 of Table 5) esimae equaion (5) wih he wo alernaive measures of excess demand and he wo alernaive measures of sock marke overvaluaion. For models 9 and moneary policy is unsable (i.e. c 4 < ). This resul is a bi roublesome since here seems o be consensus in he lieraure ha he Greenspan years have been characerized by sable moneary policy. Our regression resuls show ha he use of UNEMGAP, which is probably a more accurae measure of he real ime percepion of excess demand (see Evans (999)) raher han CBOGAP, reduces he responsiveness of he Federal funds rae o inflaion. Adding measures of sock marke valuaion lowers he response even more. This migh be he consequence of simulaneiy bias. The response of he Federal funds rae o changes in CBOGAP and he UNEMGAP are of similar magniude and expeced sign as in he esimaes of he saic Taylor rules and suggess ha he FOMC increases he Federal funds rae in respond o increases in excess aggregae demand. As wih he saic regressions, he coefficiens on P/E are consisenly negaive and on PREMIUM consisenly posiive. The magniude of he coefficien on P/E is.5 o imes larger han in he saic regressions. The coefficiens on PREMIUM are lower in he dynamic regressions compared wih he saic regressions and are essenially equal o zero. 4

26 Figure 4 Dynamic Taylor Rules: CBOGAP versus UNRATEGAP model 7 4 model acual Nex we re-esimaed equaion (5) using curren and pas real GDP as insrumens for he measures of sock marke overvaluaion o aemp o accoun for he possibiliy of he measures of overvaluaion being endogenous in equaion (5). The resuls are repored in Table 6. The esimaed response of he Federal funds rae o inflaion and measures of excess demand are he same for IV and OLS esimaes. In models 9 and, he esimaed coefficiens on P/E raio are similar in sign and magniude o he OLS resuls repored in Table 5. The coefficiens are also saisically significan a sandard levels and larger han he esimaes in he saic Taylor rule regressions. The IV coefficien esimaes on PREMIUM are he same sign and larger bu sill saisically insignifican. To summarize, he esimaed dynamic regressions repored in Table 5 and 6 are consisen wih he resuls of he saic regressions repored in Table and 4. Adding he P/E raio as a measure of sock marke valuaion o eiher saic or dynamic Taylor rule resuls in a negaive correlaion beween he Federal funds rae and sock marke overvaluaion afer conrolling for inflaion and measures of excess aggregae demand for 5

27 all esimaed equaions excep one. In fac, as Figure 5 shows, including he P/E raio in he dynamic Taylor rule resuls in a slighly beer fi of he acual Federal funds rae. Table 6: Dynamic Taylor rules, IV esimaion Dependen Variable: Federal funds rae (mean =-0.0, sandard deviaion = 0.45) Sample: 987: o 00:4 (-saisics in parenhesis) 9 0 Consan: c (.97) (.5) (4.04) (.9) Fedfunds - : c 0.6 (.94) 0.6 (5.0) 0. (.40) 0.7 (5.7) Adjus. Param. c 0.9 (5.90) 0.5 (4.7) 0.8 (5.4) 0. (.4) Inflaion: c (.9) (.89) (.7) (.) Measure of excess demand: c 5 CBOGAP (8.47) (4.6) UNEMGAP -.80 (0.).6 (.67) Measure of sock marke valuaion: c 6 PE (-.09) (-4.6) PREMIUM - 0. (0.0) (0.0) R DW Q-saisic 4 lags (Prob). (0.68) 6.66 (0.6).7 (0.0) 5.6 (0.) Insrumens: Fedfunds -, Fedfunds -, Inflaion, CBOGAP (models 9 and 0) UNEMGAP (models and ) Growh rae of real GDP from year ago (lags 0 o ). These resuls do no suppor he hypohesis ha he Greenspan Fed has been sysemaically rying o deflae apparen speculaive bubbles in he sock marke. Raher a case can be made, as is done wih he prima facie evidence presened in secion above, 6

28 ha he FOMC has, a leas, accommodaed he apparen sock marke bubble in he mid and lae 990s. 0 Figure 5: Dynamic Taylor Ruole measure of excess demand = UNRATEGAP Federal Funds Rae model 8 model acual VAR Specificaion As a final approach o he quesion of wheher moneary policy has been sysemaically influenced by valuaion of he sock marke, we esimae he following VAR model: (5) a a a 4 0 a a a 4 0 π 0 y A( L) X 0 i S b 0 = 0 0 b b 0 0 ε 0 ε 0 ε b44 ε AS IS MP SM where he vecor [ π,, y, i, pe ], consiss of inflaion, a measure of he oupu gap, he AS AD MP SM Federal funds rae and he P/E raio respecively. The [ ε, ε, ε, ε ] is a vecor of srucural disurbances which we inerpre as shocks o he aggregae curve, he aggregae curve, moneary policy, and o he sock marke respecively. A(L) is a marix polynomial in he lag operaor L. The recursive srucure of equaion (5) can be given he following srucural inerpreaion. In he firs equaion, he only conemporaneous variables ha inflaion depends on are conemporaneous shocks o inflaion. This can be inerpreed as 7

29 a horizonal aggregae supply curve in inflaion-oupu gap space as in Taylor s (00). The second equaion can be inerpreed as an aggregae demand curve ha depends conemporaneously on inflaion. This allows shocks o inflaion o have conemporaneous effecs on oupu. The hird equaion represens moneary policy wih he Federal funds rae depending conemporaneously on inflaion and he oupu gap. This is Taylor s rule for moneary policy and assumes ha he sock marke only influences moneary policy conemporaneously hrough he effecs i has on he inflaion and oupu gap. The fourh equaion represens he sock marke, where he P/E raio depends on conemporaneous shocks o inflaion, he oupu gap and he fed funds rae which is appealing since sock marke paricipans presumably look a all available and relevan informaion when deermining he appropriae price of socks. The VAR is esimaed wih he following daa wih four lags of each variable (i.e. A(L) is of order 4) and a consan in each equaion. The daa definiions are same as in secion 7. To summarize he VAR resuls, Figure 7 shows he graphs of he impulse response funcions for he Greenspan sample period 987: o 00:. For comparison wih he Greenspan period, Figure 6 gives he resuls for he sample period 960: o 987:. Discussion of he pre-greenspan sample period 960: o 987:: Figure 6, row shows he responses of inflaion o shocks o inflaion, oupu gap, Federal funds rae and he P/E raio. Inflaion responds posiively o a gap shock. The inflaion response o a federal funds shock shows wha is called he price puzzle in he SVAR lieraure, namely ha a posiive shock o he Federal funds raes resuls in an increase in inflaion. 8

30 Figure 6: Impluse Response Funcions for Equaion (5): Sample 960: o 987:, Recursive indenificaion Shock o Variable INF GAP FFR PE INF GAP Response of Variable FFR PE This apparen anomalous resul may he oucome of he fed increasing he Federal funds rae in anicipaion of higher inflaion. Shocks o he P/E raio have lile effec on inflaion. Row shows he response he oupu gap o shocks o inflaion, fed funds rae and he P/E raio. The resuls are consisen wih economic heory. An inflaion shock causes a decline in he oupu gap as does a shock o he Federal funds rae. The gap increases when here is a shock o he PE raio, which is consisen wih a wealh effec running from he sock marke o consumpion o oupu. Row 4 gives he responses of he PE raio o shocks o inflaion, gap and fed funds rae. Posiive shocks o inflaion resul in a decline in he PE raio. The same is rue of gap shocks ha are somewha surprising. However perhaps a posiive gap shock, given ha i is emporary, increases 9

31 curren earnings more han sock prices. A posiive shock o he Federal funds rae resuls in a decrease in he P/E raio. In summary, from 960 o 987 he response of he P/E raio o inflaion gap and Federal funds rae shocks is consisen wih wha one would expec from economic heory. Row shows ha he Federal funds rae responds posiively o inflaion and gap shocks which is consisen wih Taylor s moneary policy rule. The Federal funds rae also responds posiively o shocks o he P/E raio alhough he effecs are insignificanly differen from zero. These resuls sugges ha in he sample period 960 o 987, moneary policy, as measured by he Federal funds rae was responding o posiively inflaion and oupu gap shocks and also posiively o P/E shocks alhough he esimaed effec is saisically insignifican. Discussion of he Greenspan sample period 987: o 00:: Figure 7, row shows ha he response of inflaion o a gap shock is similar o figure 6. However shocks o he fed funds rae now have lile effec on inflaion (so here is no price puzzle) and shocks o he P/E resul in decreases in inflaion. This is consisen wih he new economy inerpreaion ha increases in he P/E raio in he lae 990s corresponded o posiive produciviy shocks. Row, figure 7 shows ha for he Greenspan sample period he oupu gap seems o be responding mainly o shocks o he oupu gap, wih shocks o inflaion, fed funds and P/E having lile impac on he oupu gap. Row 4 gives he response of P/E o inflaion and gap shocks is similar o he resuls presened in figure 6. In he sample period, however, fed funds shocks have lile effec on he P/E raio. Row, figure 7 presens he responses of moneary policy o shocks. Boh inflaion and oupu gap shocks resul in an increase in he fed funds rae. 0

32 Ineresingly and in conras o he figure 6, he fed funds rae responds negaively, bu no saisically significan, o a posiive shock o he P/E. This resul suggess ha moneary policy was no sysemaically responding o changes in sock marke valuaion and hus essenially acily accommodaed he apparen sock bubble in he lae 990s. Figure 7: Impluse Response funcsions for equaion (5), Sample 987: o 00:4, Recursive Idenificaion Shock o variable:.5 INF.5 GAP.5 FF.5 PE INF GAP Response of variable: FF PE Conclusions The review of he lieraure does no offer a conclusive answer of wheher and how should he Fed respond o asse bubbles. In conras o he inconclusiveness of he normaive quesion should moneary policy respond o sock marke overvaluaion?, he posiive quesion has moneary policy responded o sock marke overvaluaion?

33 can be answered by examining he daa. This paper examines empirically if moneary policy, under Greenspan, has been influenced by he high valuaion of he sock marke using differen mehodologies. The resuls sugges ha raher han he Greenspan FOMC using he Federal funds rae policy o offse increases in he value of he sock marke above esimaes of fundamenals, federal funds policy has, perhaps inadverenly, on average, accommodaed he apparen sock marke overvaluaion. Chairman Greenspan s jaw boning of he sock marke in he lae 990s, may have been an aemp o find anoher policy insrumen o influence he sock marke in he direcion of esimaes of fundamenals. The evidence from he FOMC minues, consisen wih Taylor s rule, suggess he Federal funds rae arge has largely been se in response o inflaion and measures of excess demand and, a leas, has no been increased solely o offse a poenial sock marke overvaluaion. The augmened Taylor rule indicaes ha he Fed funds raes migh have been slighly higher had he Fed compleely ignored he overvaluaion of he marke as measured by he S&P500 Index. This evidence suggess ha he Fed has no aken he risk o increase fed funds aggressively in order o reduce speculaion, a leas during he period, being aware of he poenial overreacion of he sock marke. The daa sugges ha he Greenspan Fed has had no inenions, beyond he rheoric of "irraional exuberance" o acually orchesrae a rapid correcion of he sock marke's overvaluaion because of he desabilizing effecs of declining asse prices on he economy.

34 References Benhabib, Jess, Sephanie Schmi-Grohe and Marin Uribe, (998), "The Perils of Taylor Rules", working paper, New York Universiy. Bernanke, Ben and Mark Gerler (999), Moneary Policy and Asse Price Volailiy in New Challenges for Moneary Policy, Federal Reserve Bank of Kansas Ciy. Bernanke, Ben and Mark Gerler (00), Should Cenral Banks Respond o Movemens in Asse Prices? American Economic Review: Papers and Proceedings, 9, pp Blanchard, Olivier (000), Bubbles, Liquidiy raps, and Moneary Policy: Commens on Jinushi e al, and on Bernanke, working paper, Deparmen of Economics, MIT. Bordo, Michael and Olivier Jeanne (00), "Asse Prices, Reversals, Economic Insabiliy and Moneary Policy", Paper presened a he Allied Social Science Associaion Meeings in New Orleans, Louisiana. Bullard, James and Eric Schaling (00), Why he Fed Should Ignore he Sock Marke, Review of he Federal Reserve Bank of S. Louis, 84, March/April, pp.5-4. Cecchei, Sephen, (998), "Policy Rules and Targes: Framing he Cenral Banker's Problem", Economic Policy Review of he Federal Reserve Bank of New York, June, pp.- 4. Cecchei, Sephen, Hans Genber, John Lipsky and Sushil Wadhwani, (000) Asse Prices and Cenral Bank Policy, London: Inernaional Cener for Moneary and Banking Sudies. Cecchei, Sephen and Sefan Krause (000), "Financial Srucure, Macroeconomic Sabiliy and Moneary Policy", paper presened a he XII Symposium of Moneda y Credio, Madrid, Spain. Chappell, Henry Jr. and Rob Roy McGregor (000), "A Long Hisory of FOMC Voing Behavior", Souhern Economic Journal, 66, pp Clarida, Richard, Jordi Gali and Mark Gerles, (000), "Moneary Policy Rules and Macroeconomic Sabiliy: Evidence and Some Theory", Quarerly Journal of Economics, 65, pp Cogley, Timohy, (999), "Should he Fed Take Deliberae Seps o Deflae Asse Price Bubbles?", Economic Review of he Federal Reserve Bank of San Francisco, Number, pp.4-5.