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Variations in effects of monetary policy on stock market

returns in the past four decades

Ling T. He T

Department of Economics and Finance, University of Central Arkansas, Conway, AR 72035, United States

Received 21 January 2005; received in revised form 28 April 2005; accepted 18 July 2005

Available online 30 August 2005

Abstract

Stock prices are sensitive to monetary policy. However, the sensitivities are not stable over time. A drastic change

in monetary policy can alter effects of monetary policy on stock returns. This study finds that stock prices can be

affected by current changes, unexpected changes, or near-future changes in the funds/discount rates, due to different

policy goals or targets in different periods. Specifically, this study provides empirical evidence that monetary policy

influences the stock market in different ways in the 1960s, the 1970s, the Volcker and Greenspan periods.

D 2005 Elsevier Inc. All rights reserved.

JEL classification: E52; G12

Keywords: Monetary policy; Stock returns; The funds rate; Instability

1. Introduction

The relationship between changes in the effective federal funds/discount rates and stock prices

attracted numerous studies in the past three decades. Empirical evidence in the literature suggests that

fluctuations in stock prices, from a long-run perspective, merely reflect alterations in some principaleconomic factors. As an indicator of fundamental economic changes, fluctuations in stock prices have

received close attention from the Federal Reserve and become an influential factor in the determination

of monetary policy (Bernanke & Gertler, 1999; Rigobon & Sack, 2001). In their research, Rigobon and

Sack (2001) find a significant contemporaneous and simultaneous response of monetary policy to stock

1058-3300/$ - see front matterD 2005 Elsevier Inc. All rights reserved.

doi:10.1016/j.rfe.2005.07.001

T Tel.: +1 501 450 5334; fax: +1 501 450 5203.

E-mail address: [email protected].

Review of Financial Economics 15 (2006) 331349

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market movement, that is, ba 5% rise (fall) in the S&P 500 index increasing the likelihood of a 25 basis

point tightening (easing) by about a halfQ.

On the other hand, many studies report that changes in the federal funds/discount rates cansignificantly affect or predict stock market returns by influencing forecasts of some financial variables

(Patelis, 1997). Generally speaking, an increase in the funds/discount rates pushes up market-determined

interest rates, then leads to a higher cost of capital and lower profitability, causing a negative response

from the stock market. The significant impact of monetary policy has been detected by daily and

intraday stock return data (Cook & Hahn, 1988; Jensen & Johnson, 1993; Smirlock & Yawitz, 1985;

Waud, 1970), monthly and quarterly data (Jensen & Johnson, 1995), and international stock return data

(Conover, Jensen, & Johnson, 1999a, 1999b; Conover, Jensen, Johnson, & Mercer, 2005; Durham,

2001). When innovations in the federal funds rate and nonborrowed reserves are used as the proxies for

monetary policy, Thorbecke (1997) finds evidence that monetary policy exerts large effects on ex-ante

and ex-post stock market returns. Further, Jensen and Mercer (2002) report that changes in the funds/

discount rates can significantly affect the cross-section of expected stock returns.Some studies find that the relationship between monetary policy and stock returns is consistent. For

example, Conover et al. (2005) conclude that periods of expansive monetary policy are associated with

strong stock performance, whereas periods of restrictive monetary policy generally coincide with weak stock

performance, and bthe mid-1990sQ is the only exception over the period of July 19, 1962 to January 2, 2001.

However, according to Durham (2001, 2003a, 2003b), the impact of monetary policy on stock returns is bless

sturdyQ and highly sensitive to alternative proxies of both monetary policy and stock returns as well as the

selection of the sample period. In his cross-country study (2001), Durham finds that changes in the discount

rate have a significant impact on stock returns for the sample period of 19562000. Nevertheless, the impact

is insignificant for a subperiod of 19561970. His results suggest that the relationship between monetary

policy and stock market returns may be unstable or time-varying. Although this instability issue is important,there are no further studies in the literature to analyze how and why the relationship varies over time.

The instability of the effect of monetary policy on stock prices may be a result of drastic changes in

monetary policy. There were many shifts in the U.S. monetary policy in the Federal Reserve history. In

different economic periods, policy makers face different economic tasks, therefore, they have to use

creative tools and approaches to formulating and implementing monetary policy. This time-varying nature

of monetary policy specifies different forms of the relationship between monetary policy and stock market

returns over different periods. In addition, sensitivity of stock market returns to economic fundamentals

may be different under different economic and political conditions. Given the instability on both sides of

the equation, this paper hypothesizes that the functional forms and significance of monetary policy on

stock market returns vary over time. The major objectives of this study are to define different measures

(functional forms) to quantify the relationship between monetary policy and stock prices, and empiricallyexamine how these different measures change over time in the recent four decades.

2. Measures of monetary policy impact on stock market returns

In order to be consistent with variables used in previous studies of the relationship between monetary

policy and stock returns, this study uses the effective federal funds rate (funds rate) and discount rate as

proxies of monetary policy. The first measure of monetary policy effect on stock market returns is the

sensitivity of current changes in stock prices to current alterations in the funds rate. The correlation is

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negative as evidenced by many previous studies mentioned above. A decline in the funds rate is perceived

as an indicator of lower market interest rates and easier credit resources. Therefore, it is in the favor of the

general business community and results in a bullish stock market. Furthermore, changes in the funds ratemay also indicate expected changes in the cost of equity capital which has a negative impact on security

value. The negative sensitivity of stock prices to the funds rate may be significant in one period and

insignificant in the other. For example, if a monetary policy is very activistic in reacting to daily changes in

the funds rate and very unspecific in avoiding a hint of targeting interest rate, the funds rate cannot be

considered as a meaningful indicator of money market conditions. As a result, the stock market may not

respond to changes in the funds rate in a substantial manner. However, the response may be significant, if

the funds rate can effectively serve as an indicator of money market conditions.

The second measure of monetary policy effect on stock market returns is the sensitivity of current

changes in stock prices to unexpected alterations in the funds rate. The unexpected changes in the funds

rate represent surprising changes that can be results of a drastic shift in monetary policy. Changes in the

target and procedure of monetary policy are examples for drastic policy changes. If these changesessentially differ from the past, that is, they cannot be effectively explained by past changes in the funds

rate, then responses from the stock market may be significant. The responses to unexpected changes of

monetary policy can be positive if changes are perceived favorable to businesses; on the other hand, the

responses may be negative if changes are perceived unfavorable. The unexpected alterations in the funds

rate or discount rate are measured by residuals from the following regression model:

Ratet X12

i1

bti Rateti et; 1

where Rate represents percentage changes in the funds rate or discount rate.

The third measure of monetary policy effect on stock market returns is the sensitivity of currentchanges in stock prices to one-period lead-term of changes in the funds/discount rates. Under a very

transparent and forward-looking monetary policy, expected future changes, not current changes, in the

funds/discount rates may effectively serve as an indicator of strength of the overall economy, not just an

indicator of money market conditions. Current changes in the funds/discount rates are the immediate

reflections of money market conditions; while expected future changes essentially reflect the Federal

Reserves assessment of broad economic conditions under a forward-looking monetary policy.

Therefore, if investors share the Federal Reserves assessment, it is possible that changes in stock

market and future alterations in monetary policy are in the same direction. One example is the period of

2000 through 2002. During this period investors accurately predicted the Federal Reserves near-future

actions to lower the funds/discount rates many times, while the stock market kept declining.

3. Model and data

In order to measure the three forms of effect of monetary policy on stock market returns, the following

regression model is estimated:

SPt a bR Ratet bS Resit bL Ratet1 bP PPIt bj JANUARY et; 2

where SPt represent monthly percentage changes in the S&P 500 Index; Ratet are monthly current

percentage changes in the federal effective funds rate/discount rate; Resit are residuals from Eq. (1) for

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the funds rate/discount rate; Ratet+1 are 1-month lead-terms of percentage changes in the funds rate/

discount rate; PPIt represent percentage changes in the Producer Price Index; and JANUARY is a

dummy variable with a value of 1 for January or 0 otherwise. There are two reasons for using PPI as acontrol variable for inflation: first, inflation was a very serious problem in the 1970s; and second,

inflation can directly affect stock prices and monetary policy. Therefore, in order to effectively examine

the influence of monetary policy on stock returns, it is imperative to put the impact of inflation on stock

returns under control. The reason for including JANUARY is obvious, because the variable can catch the

possible bJanuary effectQ which is widely evidenced in the literature on stock market anomalies (Haugen

& Lakonishok, 1987; Keim, 1983; Rozeff & Kinney, 1976). This study uses monthly data, therefore,

JANUARY can be a relevant control variable.

The monthly federal effective funds rate and discount rate are downloaded from the website of the

Federal Reserve System. The PPI data is from the Bureau of Labor Statistics, U.S. Department of Labor.

The S&P 500 Index is from Standard and Poors Statistical Service, except for the years after 2000

which are downloaded from Yahoo.com. This data set covers a period of January 1961 through January2003. The actual estimation period for the regression model (2) is January 1962 to December 2002.

According to Meulendyke (2003), the Federal Reserve and U.S. monetary policy experienced some

considerable changes over this 41-year sample period: (1) the period of the 1960s. The primary tool of

monetary policy during the period was free reserves, differences between excess and borrowed reserves

(from the discount window), not the funds rate. Economic expansion and price stability were the policy

goals. (2) The period of the 1970s. Given the growing inflationary pressure during the period, reducing

inflation became the ultimate goal of monetary policy. In 1970, the Federal Reserve formally adopted

monetary targets and used the funds rate to control money growth. Consequently, the funds rate, not free

reserves, became the primary guide to daily open market operations. (3) The Volcker period (August

1979August 1987). In order to curb the acceleration of inflation, then Federal Reserve Chairmen, PaulVolcker developed some strong measures. For instance, higher floating limits, 4 to 5 percentage points,

on the funds rate were established and applied only to weekly average, rather than daily levels. At the

same time, Chairman Volcker emphasized the role of nonborrowed reserve targeting on money growth

control. As a result, bpolicy actions were less immediately apparent to the market than they had been,Q

market participants had to project near-term variations in the funds rate, bbased upon their reading of

money and other economic variables,Q because there was no funds rate target (Meulendyke, 2003). (4)

The Greenspan period. Effective funds rate targeting was used to productively contain inflationary

pressures under the guidance of Federal Reserve Chairman Greenspan. Monetary policy becomes the

most transparent and forward-looking in Federal Reserve history. Preferred funds rates have been

mentioned in the press releases since 1994.

It is expected that major shifts in monetary policy over the four periods may cause substantialvariations in sensitivities of stock prices to changes in the funds rate/discount rate defined in the

regression model (Eq. (2)). This study applies the model to each of the four periods to explore how the

three forms of monetary policys impact on stock prices vary over time.

4. Empirical results

The summary statistics and regression results are reported for the entire sample period (January 1962

December 2002) in Table 1. The average funds rate (6.60%) was slightly higher than the average

http://www.yahoo.com/http://www.yahoo.com/

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Table 1

Entire sample period (January 1962December 2002)

Variable Mean Standard deviation Variable Mean

STOCK 0.58 3.55 PERFUND 0.08

PPI 0.30 0.71 LEDDISCT 0.19

FUND 6.60 3.22 LEDFUND 0.10

DISCT 5.90 2.53 RESDISCT 0.08

PERDISCT 0.19 4.12 RESFUND 0.03

Correlations: STOCK PERFUND RESFUND LEDFUND

STOCK 1.00

PERFUND 0.18 1.00

RESFUND 0.15 0.82 1.00

LEDFUND 0.03 0.54 0.40 1.00

PPI 0.15 0.26 0.14 0.22

Correlations: STOCK PERDISCT RESDISCT LEDDISCT

STOCK 1.00

PERDISCT 0.15 1.00

RESDISCT 0.08 0.87 1.00

LEDDISCT 0.02 0.46 0.43 1.00

PPI 0.15 0.18 0.06 0.19

Model CONST PERFUND RESFUND LEDFUND PPI

O L S e s t i ma t es b a se d o n t h e f u n d s r a t e

1 0.006 (0.002)*** 0.085 (0.025)***

2 0.006 (0.002)*** 0.184 (0.050)*** 0.132 (0.057)**

3 0.006 (0.002)*** 0.205 (0.050)*** 0.122 (0.057)** 0.061 (0.028)**

4 0.007 (0.002)*** 0.159 (0.052)*** 0.080 (0.058) 0.073 (0.028)*** 0.007 (0.002)***

O L S e s t i ma t es b a se d o n t h e d i s c ou n t r a te

1 0.005 (0.002)*** 0.158 (0.038)***

2 0.005 (0.002)*** 0.158 (0.068)*** 0.000 (0.082)

3 0.006 (0.002)*** 0.214 (0.074)*** 0.015 (0.082) 0.086 (0.046)*

4 0.007 (0.002)*** 0.161 (0.075)** 0.015 (0.082) 0.094 (0.045)** 0.007 (0.002)**

STOCK=Monthly percentage changes in the S&P 500 Stock Index.

PPI=Monthly percentage changes in the Producer Price Index.FUND and DISCT= Annual effective federal funds rate and discount rate, respectively.

PERFUND and PERDISCT= Monthly percentage changes in the federal funds/discount rates.

LEDFUND and LEDDISCT= One-month lead terms of PERFUND and PERDISCT.

RESFUND and RESDISCT= Residuals from Eq. (1) for the funds/discount rates, respectively.

JANUARY=A dummy with a value of 1 for January and 0 otherwise.

CONST =Constant terms.

R2=Coefficient of determination in percentage.

Standard errors of regression coefficients are in parentheses.

*, **, and *** represent the 10%, 5%, and 1% significance levels, respectively.

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discount rate (5.90%). However, the monthly percentage change for the funds rate (0.08%) was much

larger than that for the discount rate (0.19%). The result reflects the fact that the federal funds market

was getting bigger and more important over years. For the same period, the monthly stock market returnswere 0.58% and the producer price level increased, on average, by 0.30% every month. Correlations

among the three measures of monetary policys impact on stock prices indicate that current changes and

unexpected changes are more highly correlated than correlations between lead changes and current

changes/unexpected changes. Although all three measures are included in the regression model (Eq. (2)),

results of principal components and factor analysis (not reported in Table 1) do not suggest any

significant multicollinearity difficulties in the three measures. The highest condition index is only 3.86

which indicates very weak linear dependencies among them (Belsley, Kuh, & Welsch, 1980). However,

in order to clearly examine the three measures of monetary policys effect on stock returns, the following

three simple models are estimated prior to the estimation of Eq. (2): first, stock returns are explained by

current changes in monetary policy only; second, both current and unexpected changes in monetary

policy are used as independent variables; and third, all three measures, current, unexpected and leadchanges, are included in the model.

Regression results of models 13 indicate that stock prices are very sensitive to current percentage

changes as well as unexpected and lead changes in the funds rate (Table 1). Nevertheless, when variables

of PPI and JANUARY are included in the model, the coefficient of the unexpected changes (RESFUND)

shrinks by one third, from 0.122 to 0.080. Given a similar standard error of 0.058 (vs. 0.057), the

coefficient loses its significance. This result suggests that PPI and JANUARY can capture stock market

variations initially explained by the unexpected changes in the funds rate. In other words, variations in

stock prices explained by the unexpected changes may be a part of inflation and January effects.

According to the result of Model 4, stock returns are very sensitive to current changes in the funds rate

and their lead-terms. The coefficients are 0.159 and 0.073, respectively; and both are significant at the1% level. In other words, two different monetary policy effects on stock market returns exist. First,current changes in the funds rate, as an immediate indicator of money market conditions, can negatively

affect the stock market as expected. Second, changes in the funds rate 1 month ahead have a positive

impact on current stock prices. This may suggest that monetary policy is transparent at least in most

years of the 41-year sample period. Furthermore, the positive sign for the coefficient of the lead-term

suggests that investors understand or share the Federal Reserves assessment on the strength of economy,

given the impact of inflation controlled by PPI in model 4. As a result, both stock prices and the funds/

discount rates vary in the same direction. In addition, the significant coefficient of PPI indicates that

inflation plays an important negative role in determining stock market returns. Regression results also

clearly indicate anomalies in the stock market. That is, a strong January effect exists over the entire

sample period. The discount rate data portrays a very similar picture about different functional forms ofmonetary policys impact on stock returns.

In order to analyze how and why these forms vary over time, it is necessary to examine four important

periods known for major shifts in monetary policy.

5. The period of January 1962December 1969

Table 2 contains results about this period. None of the three measures of monetary policys effect on

stock prices are found to be statistically significant. The results are in line with Durhams (2001) finding


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that the U.S. monetary policy could not significantly affect stock prices over the period of 19561970.

Inflation in the 1960s was low, only about half of the average for the entire sample period. Policy makers

did not pay much attention to targeting the funds rate, instead, focused on free reserves as the gauge for

Table 2

Period of the 1960s (January 1962December 1969)

Variable Mean Standard

deviation


deviation

STOCK 0.30 3.06 PERFUND 1.55 5.39

PPI 0.15 0.35 LEDDISCT 0.76 2.81

FUND 4.58 1.72 LEDFUND 1.64 5.31

DISCT 4.19 0.94 RESDISCT 0.21 2.75

PERDISCT 0.76 2.81 RESFUND 0.76 4.89

Correlations: STOCK PERFUND RESFUND LEDFUND PPI

STOCK 1.00

PERFUND 0.04 1.00RESFUND 0.03 0.89 1.00LEDFUND 0.07 0.29 0.28 1.00PPI 0.09 0.21 0.13 0.33 1.00

Correlations: STOCK PERDISCT RESDISCT LEDDISCT PPI

STOCK 1.00

PERDISCT 0.06 1.00

RESDISCT 0.00 0.86 1.00LEDDISCT 0.07 0.32 0.36 1.00PPI 0.12 0.13 0.07 0.17 1.00

Model CONST PERFUND RESFUND LEDFUND PPI JANUARY R2


1 0.003 (0.003) 0.011 (0.059) 0.04

2 0.003 (0.003) 0.058 (0.116) 0.060 (0.127) 0.273 0.004 (0.004) 0.026 (0.118) 0.006 (0.135) 0.075 (0.064) 1.724 0.004 (0.004) 0.065 (0.121) 0.036 (0.137) 0.065 (0.065) 0.012 (0.010) 0.011 (0.012) 3.92

O L S e s t i ma t es b a se d o n t h e d i s c o un t r a te

1 0.002 (0.003) 0.065 (0.112) 0.36

2 0.001 (0.003) 0.262 (0.221) 0.233 (0.226) 1.493 0.002 (0.003) 0.266 (0.222) 0.203 (0.230) 0.091 (0.121) 2.094 0.003 (0.004) 0.279 (0.233) 0.202 (0.244) 0.065 (0.122) 0.013 (0.009) 0.005 (0.012) 4.05


PPI=Monthly percentage changes in the Producer Price Index.

FUND and DISCT= Annual effective federal funds rate and discount rate, respectively.

PERFUND and PERDISCT=Monthly percentage changes in the federal funds/discount rates.LEDFUND and LEDDISCT=One-month lead terms of PERFUND and PERDISCT.

RESFUND and RESDISCT=Residuals from Eq. (1) for the funds/discount rates, respectively.


CONST = Constant terms.




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day-to-day operations to affect bank credit growth. In order to avoid any possible hint of targeting

interest rates, this monetary policy was bdeliberately nonspecificQ (Meulendyke, 2003). As a result, the

funds rate and discount rate were not good indicators for money market conditions. Therefore, the firsttwo measures of policy effect on stock prices are not significant. The third measure is not meaningful

either, because of the nontransparent nature of the policy.

6. The period of January 1970August 1979

The average monthly inflation rate (measured by PPI) was 0.68% for the period (Table 3), more than

twice the average for the entire sample period (0.30%). The high inflation was the result of soaring oil

price and growing government size. Regression results of Model 4 suggest that stock prices are

substantially affected by the inflation: the negative coefficient for PPI is significant at the 5% level

(Table 3). Like results in Table 1, PPI, along with the dummy variable of JANUARY, may explain somechanges in stock prices previously explained by unexpected changes in the funds rate (Models 2 and 3).

Compared with results for the overall sample period and the 1960s, current changes in the funds rate play

a bigger role in affecting stock prices with a coefficient of0.352 (standard error 0.106). The resultreflects the fact that the federal funds rate gained much policy attention during the 1970s. The funds rate

replaced free reserves as the primary guide to daily open market operations in the effort to curb inflation.

However, during the 1970s the major economic problem was bstagflation,Q a combination of inflation

and recession. The Federal Reserve had to deal with both at the same time. This may be the reason why

the focus of monetary policy often swung between inflation and weaknesses in the economy

(Meulendyke, 2003). The shifts in policy focus can cause confusion in the stock market. Regression

results of models 2 and 3 provide some evidence for the confusion. The coefficients of the residuals fromEq. (1), a measure of unexpected changes in monetary policy, increase from almost 0 (Model 2, Table 2)

in the 1960s to greater than 0.264 in the 1970s (Table 3). To reduce the confusion, adjustments in the

funds rate in most of the 1970s were limited to small amounts to avoid short-term reversals of the rate,

therefore, these conservative and hesitant adjustments boften lagged behind market forces,Q that is, trends

in money, the economy, and prices got ahead of policy (Meulendyke, 2003). This is clearly evidenced by

the regression result of Model 4. The lead-term of changes in the funds rate has a coefficient of 0.152

with a standard error of 0.056. It means that near-future changes in the funds rate followed and were in

line with market forces.

Since the discount rate was not served as a major indicator of money market conditions in the 1970s,

it is not surprising that the discount rate commanded much less influence on stock prices, compared with

the funds rate. Regression results in Table 3 suggest that only current changes in the discount rate cansignificantly affect stock prices.

7. The Volcker period (August 1979August 1987)

When Paul Volcker was appointed as Chairman of the Federal Reserve in August 1979, the

acceleration of inflation remained at unacceptable rates. Monetary policy in most of the 1970s adapted

inflation and economic instability by lowering real interest rates when expected inflation increased, and

vice versa. Many researchers believe that it was this bperverseQ monetary policy that caused the failure in


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Table 3

Period of the 1970s (January 1970August 1979)








STOCK 1.00

PERFUND 0.19 1.00RESFUND 0.02 0.87 1.00LEDFUND 0.15 0.43 0.49 1.00

PPI 0.00 0.21 0.15 0.35


STOCK 1.00

PERDISCT 0.36 1.00RESDISCT 0.26 0.82 1.00LEDDISCT 0.23 0.58 0.41 1.00PPI 0.24 0.20 0.07 0.24


O L S e s ti m at e s b as e d o n t h e f u nd s r a te

1 0.003 (0.003) 0.158 (0.048)*** 2 0.003 (0.003) 0.351 (0.096)*** 0.264 (0.115)** 3 0.003 (0.003) 0.447 (0.102)*** 0.289 (0.113)** 0.135 (0.056)** 4 0.006 (0.004) 0.352 (0.106)*** 0.185 (0.118) 0.152 (0.056)*** 0.008 (0.004)**

O L S e s t i m a te s b a se d o n t h e d i s co u nt r a t e

1 0.004 (0.003) 0.417 (0.100)*** 2 0.005 (0.003) 0.531 (0.175)*** 0.173 (0.218) 3 0.005 (0.003) 0.521 (0.199)*** 0.170 (0.221) 0.014 (0.125) 4 0.007 (0.004)* 0.422 (0.197)*** 0.058 (0.220) 0.051 (0.124) 0.008 (0.004)**








CONST= Constant terms.




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Table 4

Volcker period (August 1979August 1987)




FUND 10.61 3.59 LEDFUND 0.46




STOCK 1.00

PERFUND 0.15 1.00

RESFUND 0.02 0.87 1.00

LEDFUND 0.09 0.41 0.45 1.00

PPI 0.05 0.21 0.14 0.33


STOCK 1.00

PERDISCT 0.23 1.00

RESDISCT 0.10 0.83 1.00

LEDDISCT 0.05 0.51 0.41 1.00

PPI 0.05 0.31 0.20 0.34



1 0.013 (0.004)*** 0.062 (0.042)

2 0.013 (0.003)*** 0.228 (0.083)*** 0.212 (0.092)**

3 0.013 (0.003)*** 0.231 (0.083)*** 0.187 (0.094)** 0.055 (0.046)

4 0.013 (0.004)*** 0.230 (0.085)*** 0.188 (0.097)** 0.064 (0.048) 0.004 (0.006)


1 0.012 (0.004)*** 0.229 (0.098)**

2 0.011 (0.004)*** 0.476 (0.174)*** 0.341 (0.200)*

3 0.011 (0.004)*** 0.525 (0.184)*** 0.345 (0.200)* 0.090 (0.111)

4 0.010 (0.004)** 0.531 (0.191)*** 0.349 (0.204)* 0.084 (0.116) 0.001 (0.007)



FUND and DISCT=Annual effective federal funds rate and discount rate, respectively.






R2= Coefficient of determination in percentage.



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Table 5

Volckers first term (August 1979July 1983)


deviation


deviation

STOCK 1.09 3.97 PERFUND 0.43 11.29

PPI 0.52 0.62 LEDDISCT 0.29 4.55FUND 13.10 3.36 LEDFUND 0.38 11.28

DISCT 11.47 1.78 RESDISCT 0.18 4.04PERDISCT 0.17 4.63 RESFUND 0.13 10.01


STOCK 1.00

PERFUND 0.29 1.00RESFUND 0.16 0.87 1.00LEDFUND

0.01 0.57 0.46 1.00

PPI 0.24 0.09 0.09 0.18 1.00


STOCK 1.00

PERDISCT 0.32 1.00RESDISCT 0.17 0.83 1.00LEDDISCT 0.09 0.52 0.41 1.00PPI 0.00 0.31 0.18 0.30 1.00



1 0.011 (0.006)* 0.067 (0.051) 3.642 0.012 (0.005)** 0.254 (0.099)** 0.242 (0.112)** 12.723 0.012 (0.005)* 0.255 (0.098)** 0.203 (0.115)* 0.074 (0.056) 16.084 0.012 (0.007) 0.254 (0.102)** 0.201 (0.119)* 0.073 (0.061) 0.004 (0.010) 0.004 (0.021) 16.15


1 0.010 (0.005)* 0.278 (0.120)** 10.482 0.011 (0.005)* 0.514 (0.215)** 0.324 (0.246) 13.813 0.011 (0.005)* 0.572 (0.231)** 0.332 (0.247) 0.103 (0.142) 14.834 0.007 (0.008) 0.644 (0.240)*** 0.373 (0.251) 0.094 (0.146) 0.011 (0.010) 0.020 (0.021) 17.83



FUND and DISCT= Annual effective federal funds rate and discount rate, respectively.PERFUND and PERDISCT=Monthly percentage changes in the federal funds/discount rates.

LEDFUND and LEDDISCT=One-month lead terms of PERFUND and PERDISCT.








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Table 6

Volckers second term (August 1983August 1987)


deviation


deviation

STOCK 1.44 3.03 PERFUND 0.57 4.62PPI 0.05 0.47 LEDDISCT 0.70 2.46FUND 8.18 1.59 LEDFUND 0.46 4.74DISCT 7.35 1.30 RESDISCT 0.18 1.84PERDISCT 0.86 2.09 RESFUND 0.21 4.54


STOCK 1.00

PERFUND 0.02 1.00

RESFUND 0.01 0.86 1.00LEDFUND

0.13 0.15 0.30 1.00

PPI 0.12 0.13 0.07 0.17 1.00


STOCK 1.00

PERDISCT 0.01 1.00

RESDISCT 0.09 0.84 1.00

LEDDISCT 0.04 0.47 0.44 1.00

PPI 0.09 0.31 0.33 0.46 1.00



1 0.014 (0.004)*** 0.025 (0.096) 0.142 0.014 (0.004)*** 0.045 (0.212) 0.023 (0.216) 0.173 0.014 (0.005)*** 0.036 (0.215) 0.026 (0.218) 0.039 (0.100) 0.514 0.013 (0.005)*** 0.047 (0.221) 0.059 (0.224) 0.014 (0.105) 0.007 (0.010) 0.020 (0.017) 4.19


1 0.015 (0.005)*** 0.020 (0.211) 0.022 0.013 (0.005)** 0.283 (0.384) 0.412 (0.437) 1.913 0.013 (0.005)** 0.298 (0.398) 0.405 (0.443) 0.035 (0.208) 1.984 0.013 (0.005)** 0.268 (0.399) 0.439 (0.445) 0.095 (0.223) 0.011 (0.011) 0.019 (0.016) 6.90



FUND and DISCT= Annual effective federal funds rate and discount rate, respectively.PERFUND and PERDISCT=Monthly percentage changes in the federal funds/discount rates.

LEDFUND and LEDDISCT=One-month lead terms of PERFUND and PERDISCT.



CONST=Constant terms.



**, and *** represent the 5% and 1% significance levels, respectively.


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efforts of reducing inflation (Clarida, Gali, & Gertler, 2000; Orphanides, 2001; Taylor, 1999). Chairman

Volcker reversed the policy by taking strong measures to rebuild public confidence in the Federal

Reserve. Volcker was convinced that real interest rates must rise considerably beyond recent level todetain inflation. Moreover, the federal funds rate should have wider variable ranges and these limits be

applied only to weekly averages. Consequently, the funds rate and discount rate were much higher in the

Volcker period (Table 4), especially during his first term (Table 5), than in the 1970s (Table 3), and so

were standard deviations for the two rates. Stock prices kept a high sensitivity to changes in the funds

rate, as suggested by regression results in Tables 4 and 5.

Nevertheless, under the leadership of Volcker, the target of monetary policy switched to nonborrowed

reserves to achieve greater control over M1 and the funds rate was used as an indicator of the accuracy of

reserve estimates (Meulendyke, 2003). The changes meant that there was no longer the funds rate target,

market participants had to make their own projections on alterations in the funds rate. This shift in policy

deviated from the traditional path and caused notable confusion for Fed watchers. It is evidenced by the

significant coefficient estimates for unexpected changes in the funds rate (Tables 4 and 5). Furthermore,the insignificant coefficient estimates for lead-terms of the funds rate are consistent with the fact that

monetary policy actions were bless immediately apparent to the marketQ than they had been in most of

the 1970s under nonborrowed reserve targeting (Meulendyke, 2003). Virtually the same results are found

for the discount rate.

The policy changes mentioned above happened in the early years of Volckers first term, therefore,

results reported in Tables 4 (for two terms) and 5 (for the first term) are similar. Nonetheless, results for his

second term are different. All three measures of policy effect have insignificant coefficients (Table 6).

Again, the results mirror a fundamental change in monetary policy. Borrowed reserves, rather than

nonborrowed reserves, were the target of monetary policy in Volckers second term. As a result, the funds

rate was allowed a much smaller degree of variation and even less transparency under the borrowed reservetargeting procedures than the previous nonborrowed reserve targeting procedures (Meulendyke, 2003).

The standard deviation of the funds rate decreased from 3.36% in the first term (Table 5) to 1.59% in the

second term (Table 6). The stable funds rate can only play a minor role in affecting stock prices.

It is interesting to point out that inflation never exercised important influence on stock prices during

Volckers two terms, given very high inflation in his first term. The possible explanation is that people

changed their expectations for inflation after experienced the Great Inflation in most of the 1970s, and

believed that the inflation had become a permanent phenomenon. Furthermore, there is no evidence for

the significant January effect during Volckers terms.

8. The Greenspan period (August 1987December 2002)

Alan Greenspan was initially appointed as the Chairman of the Federal Reserve in August 1987 and

reappointed four times in a row. Chairman Greenspan started his fifth and final term in 2003. Some

important events had happened during his tenure. The most notable one was the stock market crash on

October 19, 1987. In order to make sure that sufficient credit was available to the market, the funds

rate was used as an indicator of reserve levels. Once again, the effective federal funds rate became the

target of monetary policy, because it was apparent in early 1988 that despite the shock from the stock

market, the economy was growing rapidly. Nonetheless, the funds rate was not managed as closely as

in the 1970s (Meulendyke, 2003). The regression models produce consistent results (Tables 79):


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Table 7

Greenspan period (August 1987December 2002)








STOCK 1.00

PERFUND 0.09 1.00

RESFUND 0.10 0.86 1.00

LEDFUND 0.12 0.54 0.41 1.00

PPI 0.12 0.37 0.20 0.15


STOCK 1.00

PERDISCT 0.13 1.00

RESDISCT 0.16 0.83 1.00

LEDDISCT 0.12 0.55 0.40 1.00

PPI 0.12 0.32 0.19 0.16



1 0.006 (0.003)** 0.067 (0.057)

2 0.006 (0.003)** 0.010 (0.113) 0.077 (0.134)

3 0.007 (0.003)** 0.138 (0.121) 0.035 (0.132) 0.179 (0.067)***

4 0.007 (0.003)** 0.052 (0.130) 0. 096 (0.136) 0.166 (0.067)*** 0.007 (0.005)

O L S e s ti m at e s b a se d o n t h e d i sc o un t r a te

1 0.006 (0.003)** 0.091 (0.052)*

2 0.006 (0.004)** 0.002 (0.092) 0.138 (0.113)

3 0.007 (0.003)** 0.124 (0.099) 0.099 (0.112) 0.182 (0.062)***

4 0.007 (0.003)** 0.070 (0.105) 0. 127 (0.113) 0.173 (0.061)*** 0.007 (0.005)


PPI=Monthly percentage changes in the Producer Price Index.FUND and DISCT= Annual effective federal funds rate and discount rate, respectively.









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Table 8

Period of August 1987December 1993






PERDISCT

0.72 3.42 RESFUND

0.46


STOCK 1.00

PERFUND 0.10 1.00

RESFUND 0.06 0.84 1.00

LEDFUND 0.11 0.34 0.23 1.00

PPI 0.39 0.37 0.22 0.15


STOCK 1.00

PERDISCT 0.26 1.00

RESDISCT 0.16 0.83 1.00

LEDDISCT 0.07 0.38 0.26 1.00

PPI 0.39 0.22 0.12 0.14



1 0.005 (0.004) 0.089 (0.106)

2 0.005 (0.004) 0.143 (0.201) 0.068 (0.214)

3 0.006 (0.004) 0.219 (0.208) 0.098 (0.214) 0.151 (0.113)

4 0.011 (0.004) 0.084 (0.203) 0.068 (0.199) 0.163 (0.103) 0.029 (0.007)***


1 0.004 (0.004) 0.263 (0.114)**

2 0.003 (0.004) 0.419 (0.206)** 0.201 (0.221)

3 0.004 (0.004) 0.532 (0.213)** 0.242 (0.219) 0.214 (0.212)*

4 0.008 (0.004)** 0.317 (0.211) 0.117 (0.209) 0.224 (0.114)* 0.024 (0.007)***



FUND and DISCT =Annual effective federal funds rate and discount rate, respectively.PERFUND and PERDISCT= Monthly percentage changes in the federal funds/discount rates.








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Table 9

Period of January 1994December 2002


deviation


deviation

STOCK 0.68 3.75 PERFUND 0.65 5.27PPI 0.11 0.67 LEDDISCT 1.06 6.09FUND 4.77 1.41 LEDFUND 0.68 5.27DISCT 4.30 1.41 RESDISCT 0.43 4.75PERDISCT 1.06 6.09 RESFUND 0.33 4.27


STOCK 1.00

PERFUND 0.08 1.00RESFUND 0.11 0.87 1.00LEDFUND 0.13 0.61 0.49 1.00

PPI 0.03 0.33 0.19 0.15 1.00


STOCK 1.00

PERDISCT 0.08 1.00RESDISCT 0.16 0.83 1.00LEDDISCT 0.14 0.59 0.43 1.00

PPI 0.03 0.36 0.21 0.17 1.00



1 0.006 (0.004)* 0.059 (0.069) 0.69

2 0.007 (0.004)* 0.051 (0.141) 0.156 (0.174) 1.443 0.007 (0.004)** 0.098 (0.153) 0.114 (0.172) 0.195 (0.086)** 6.054 0.006 (0.004)* 0.127 (0.169) 0.097 (0.182) 0.197 (0.088)** 0.004 (0.006) 0.004 (0.014) 6.57


1 0.006 (0.004)* 0.052 (0.060) 0.702 0.007 (0.004)* 0.089 (0.105) 0.218 (0.134) 3.133 0.007 (0.004)** 0.028 (0.115) 0.185 (0.133) 0.164 (0.072)** 7.724 0.007 (0.004)* 0.052 (0.124) 0.172 (0.136) 0.166 (0.073)** 0.004 (0.006) 0.002 (0.013) 8.11




PERFUND and PERDISCT=Monthly percentage changes in the federal funds/discount rates.LEDFUND and LEDDISCT=One-month lead terms of PERFUND and PERDISCT.



CONST=Constant terms.



* and ** represent the 10% and 5% significance levels, respectively.


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coefficients for current changes and unexpected changes in the funds rate are not statistically

significant.

Since Volckers second term, monetary policy has been based on a number of factors, such as economicactivities, inflation, exchange rates, financial market conditions, etc. Although the approach is adopted in

managing the funds rate in the Greenspan period, a substantial change in policy-making process was made

in 1994. In order to avoid or reduce misunderstandings about the stance of policy or delay in recognizing

changes in the funds rate, a procedure to announce changes in policy stance on the day they were made

began in 1994. Moreover, the short-term objective for the open market operation or the target level for the

funds rate has been explicitly stated in the press releases since 1995 (Edwards, 1997). As a result,

the transparent and forward-looking policy literally facilitate market participants to better understand the

implied projections of future changes in economic activities revealed in the funds rate. This may be the

reason why the lead-term of changes in the funds rate has significant coefficients for the Greenspan period

and the subperiod of 19942000, in particular (Tables 7 and 9); while the coefficients are insignificant for

the subperiod of 19871993 which is prior to the change in policy-making process (Table 8). Furthermore,it is important to know that although the adjustments in the funds rate are cautious and lagged behind

perception of market forces in both periods of 19942000 and the 1970s, they are consequences of different

monetary policies: a transparent and forward-looking policy vs. a hesitant one.

Results based on the discount rate are in line with the above findings, except for the period of 1987

1993. Both current changes and changes 1 month ahead in the discount rate have significant coefficients

in the period (Table 8). The results may reflect the fact that banks were more willing to borrow from the

discount window in the late 1980s (Meulendyke, 2003).

9. Conclusions

Major shifts in monetary policy can essentially shape the time-varying relationship between monetary

policy and stock prices through changes in the funds/discount rates, unexpected rates changes, and near-

future rates changes. These three forms of the relationship may play different roles in affecting stock

prices, due to different policy goals or targets in different periods. Free reserves were the target of

monetary policy in the 1960s, accordingly, the funds/discount rates were not perceived as indications of

money market conditions. Therefore, all three effects of the funds/discount rates on stock market returns

were insignificant.

In the 1970s, the target of monetary policy switched from free reserves to the funds rate. As a result,

current changes in the funds/discount rates became a powerful factor in determining stock prices. During

the battle against bstagflationQ, the focus of monetary policy often swung between inflation and theeconomys weaknesses. The unstable policy increased the influence of unexpected changes in the funds

rate on stock returns. The Federal Reserve was reluctant to make any big changes in the funds rate during

the period. Accordingly, the significant influence of near-future changes in the funds rate on stock prices in

the 1970s merely reflected the fact that adjustments in the funds rate often lagged behind market forces.

Drastic policy changes in Volckers first term as Chairman of the Federal Reserve completely

eliminated conservative and hesitant policy procedures. The funds/discount rates were much higher than

that in the 1970s. Current changes in these rates kept their substantial influence on stock prices.

However, at the same time, the target of monetary policy switched to nonborrowed reserves. It means

that market participants must figure out changes in the funds rate by themselves. As a result, unexpected


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alterations in the funds rate remained an influential factor in the stock market. Monetary policy actions

under the nonborrowed reserve targeting were not immediately apparent to the market. The

nontransparency of monetary policy determined that changes in the lead-terms of funds/discount ratescould not significantly affect stock prices. In Volckers second term, borrowed reserves became the target

of monetary policy. The funds rate was allowed a much smaller degree of variation and even less

transparency under the borrowed reserve targeting procedures than the previous nonborrowed reserve

targeting procedures. As a result, all three effect measures of the funds/discount rates on stock market

returns were insignificant.

Although the target of monetary policy switched back to the funds rate in the late 1980s, it was not

managed as closely as in the 1970s. Changes in the funds rate, therefore, could not meaningfully affect

stock prices in the Greenspan period (19872000). Nevertheless, a new policy procedure that took into

effect in 1994 made the stock market more sensitive to near-future changes in the funds/discount rates,

due to the greatly increased transparency and forward-looking in monetary policy.

Overall, this study finds evidence that monetary policy plays an important role in explainingvariations in stock prices in the past four decades. The finding is consistent with many previous studies.

More importantly, evidence of this study clearly indicates that monetary policy may affect stock returns

in different ways in different periods, due to major shifts in monetary policy. For example, both current

and unexpected changes in monetary policy had important effects on stock returns in the Volcker period;

however, only lead changes in monetary policy may significantly influence stock prices in the Greenspan

period.

Acknowledgements

The author greatly appreciates the helpful comments and suggestions of Shao C. He, Joseph

McGarrity, and an anonymous referee. All errors are the responsibility of the author. This study is funded

by the University of Central Arkansas.

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