On monetary policy and stock market anomalies

This study utilizes a macro-based VAR framework to investigate whether stock portfolios formed on the basis of their value, size and past performance characteristics are affected in a differential manner by unexpected US monetary policy actions during the period 1967-2007. Full sample results show that value, small capitalization and past loser stocks are more exposed to monetary policy shocks in comparison to growth, big capitalization and past winner stocks. Subsample analysis, motivated by variation in the realized premia and parameter instability, reveals that monetary policy shocks’ impact on these portfolios is significant and pronounced only during the pre-1983 period.Monetary policy, Federal funds rate, Market anomalies, Credit channel, Risk premia

On the interaction between asset prices, inflation and interest rates

This thesis was submitted for the degree of Doctor of Philosophy and awarded by Brunel University.This thesis examines the interaction between monetary policy, inflation and asset prices. The role of asset prices in the transmission mechanism of monetary policy via consumption wealth effects and investment balance sheet effects is receiving a growing degree of attention nowadays. Financial asset prices respond quickly to new information about monetary policy shifts, while the transmission of policy actions to output and inflation exhibits significant lags. Therefore, it is important to examine the feedback between interest rates and asset prices, since it will provide important insights for central bankers and investors alike. This area of the literature draws from both the monetary economics and financial economics disciplines and has become quite important given the new challenges for monetary policyrnakers in the context of fundamental changes in the underlying financial and macroeconomic framework. In this respect, we are interested in three main issues: first, to investigate the impact of the, nowadays prevalent, inflation targeting monetary policy regime on average inflation and the related inflationary uncertainty (Chapter 2); second, to establish quantitatively the existence of a transmission link from changes in the monetary policy stance to the stock market (Chapter 1); third, to examine the monetary policy reaction to asset price fluctuations (Chapters 3-5). Chapter 2 looks at the significant changes that occurred in the inflation process over the 1990s using British data. We show that post-targeting, inflation is lower, less persistent and less volatile. In chapter 3, we use data from the UK and the US and find that lower expected inflation allows monetary policy to relax by decreasing short-term interest rates. In chapter 1, international evidence suggests that decreases in interest rates exert a significantly positive impact on stock prices in the majority of the countries under investigation. Hence, the empirical evidence in chapters 1-3 is consistent with the scenario underlying the so-called 'new environment' hypothesis. Inflation targets were successful in anchoring inflation expectations and subsequently boosting stock prices due to lower interest rates. In chapters 3-5 we focus on the role of asset prices for monetary policy formulation. We present empirical (chapter 3), theoretical (chapter 4), and simulation n(chapter 5) evidence indicating that monetary policy has responded and should, in principle, respond to asset price fluctuations. Particularly, in chapter 3 we augment the standard forward-looking Taylor rule with the change in asset prices (house prices, stock prices) and find that there is a positive and statistically significant weight attached to asset price fluctuations in both the UK and the US. The estimates suggest that policyrnakers in the US are more concerned about stock market developments, while in the UK about house market developments. In chapter 4, we utilise a structural backward-looking economic model, augmented for the effect of asset prices on aggregate demand, that allows us to derive the optimal interest rate rule via dynamic minimisation of the central bank's loss function. We show that under certain assumptions about the asset price evolution, monetary policy should react to asset price misalignments from their fundamental value. Finally, in chapter 5 we simulate a forward-looking model to examine the impact on macroeconomic volatility from reacting, or not, to asset price misalignments. We find that a policy reaction that is aggressive with respect to inflation, and mild (but not zero) with respect to asset price misalignments is able to promote overall macroeconomic stability

The EMU sovereign-debt crisis: Fundamentals, expectations and contagion

We offer a detailed empirical investigation of the European sovereign debt crisis based on the theoretical model by Arghyrou and Tsoukalas (2010). We find evidence of a marked shift in market pricing behaviour from a ‘convergence-trade’ model before August 2007 to one driven by macro-fundamentals and international risk thereafter. The majority of EMU countries have experienced contagion from Greece. There is no evidence of significant speculation effects originating from CDS markets. Finally, the escalation of the Greek debt crisis since November 2009 is confirmed as the result of an unfavourable shift in country specific market expectations. Our findings highlight the necessity of structural, competitiveness-inducing reforms in periphery EMU countries and institutional reforms at the EMU level enhancing intra-EMU economic monitoring and policy co-ordination.

Monetary Policy and the Stock Market: Some International evidence

This paper investigates the impact of monetary policy on stock returns in thirteen OECD countries over the period 1972-2002. Our results indicate that monetary policy shifts significantly affect stock returns, thereby supporting the notion of monetary policy transmission via the stock market. Our contribution with respect to previous work is threefold. First, we show that our findings are robust to various alternative measures of stock returns. Second, our inferences are adjusted for the non-normality exhibited by the stock returns data. Finally, we take into account the increasing co-movement among international stock markets. The sensitivity analysis indicates that the results remain largely unchanged.

THE LONG RUN RELATIONSHIP BETWEEN STOCK PRICES AND GOODS PRICES: NEW EVIDENCE FROM PANEL COINTEGRATION

We examine the long run relationship between stock prices and goods prices to gauge whether stock market investment can hedge against inflation. Data from sixteen OECD countries over the period 1970-2006 are used. We account for different inflation regimes with the use of sub-sample regressions, whilst maintaining the power of tests in small sample sizes by combining time-series data across our sample countries in a panel unit root and panel cointegration econometric framework. The evidence supports a positive long-run relationship between goods prices and stock prices with the estimated goods price coefficient being in line with the generalized Fisher hypothesis.

Should Monetary Policy Respond to Asset Price Misalignments?

This paper analyses the relationship between monetary policy and asset prices using a structural rational expectations model that allows for the effect of asset prices on aggregate demand. We assume that asset prices follow a partial adjustment mechanism whereas they are positively affected by past changes, thus allowing for ‘momentum trading’, while at the same time we allow for reversion towards fundamentals. We then conduct stochastic simulations using two alternative monetary policy rules, inflation-forecast targeting and the standard Taylor rule. The results indicate that, under both rules, interest rate setting that takes into account asset price misalignments leads to lower overall macroeconomic volatility, as measured by the postulated loss function of the central bank.Monetary policy; Asset prices

Optimal Monetary Policy and Asset Price Misalignments

This paper analyses the relationship between monetary policy and asset prices in the context of optimal policy rules. The transmission mechanism is represented by a linearized rational expectations model augmented for the effect of asset prices on aggregate demand. Stabilization objectives are represented by a discounted quadratic loss function penalizing inflation and output gap volatility. Asset prices are allowed to deviate from their intrinsic value since they may be positively affected by past price changes. We find that in the presence of wealth effects and inefficient markets, asset price misalignments from their fundamentals should be included in the optimal interest rate reaction function.

Modeling The Non-Linear Behaviour of Inflation Deviations From The Target

This study tests for and models non-linearities in inflation deviations from the target in five OECD countries that adopted inflation targeting over the 1990s. Our tests reject the linearity hypothesis and we show that the exponential smooth transition autoregressive (ESTAR) model is capable of capturing the non-linear behavior ofinflation misalignments. The extent of inflation deviations from the target varies across the OECD countries, with countries that consistently undershoot the target having a rapid adjustment process, whereas countries that overshoot the target have a slower revision back to equilibrium.

The EURO and Inflation Uncertainty In The EMU

In this paper, we investigate empirically the relationship between inflation and inflation uncertainty in twelve EMU countries. We estimate a time-varying parameter model with a GARCH specification for the conditional volatility of inflation in order to distinguish between short-run (structural and impulse) and steady-state uncertainty. We then introduce a dummy variable to model the policy regime shift which occurred in 1999 with the introduction of the Euro, and its effects on the links between inflation and inflation uncertainty. We find that the EMU countries have had rather different experiences, and that in the post-Euro period monetary policy might have become less effective in lowering inflation uncertainty, in the sense that a monetary tightening on the part of the ECB might in result in higher uncertainty. This suggests the need for improvements in the ECB’s analytical framework.

The Euro and Inflation Uncertainty in the European Monetary Union

This paper investigates the relationship between inflation and inflation uncertainty in twelve EMU countries. A time-varying GARCH model is estimated to distinguish between short-run and steady-state inflation uncertainty. The effects of the introduction of the Euro in 1999 are then examined introducing a dummy variable. Overall, it appears that post-1999 steady-state inflation has generally remained stable, steady-state inflation uncertainty and inflation persistence have both increased, and the relationship between inflation and inflation uncertainty has broken down in many countries. When the break dates are determined endogenously, the adjustment is found to have taken place before the introduction of the EuroInflation; Inflation Uncertainty; Inflation Persistence; Time-Varying Parameters; GARCH models; ECB; EMU