Does U.S. monetary policy react to asset prices? Implications of stock market bubbles, volatility and productivity

Indian Journal of Economics and Business, Dec, 2007 by Rajeev Sooreea

Overall, not only are there divergent views about whether monetary policy reacts to asset prices, but there is also another dimension to the problem: namely, how to estimate asset price misalignments (or bubbles) and gauge the amount of volatility that asset price movements contain? This study attempts to fulfill this gap in the literature. Specifically, it tries to estimate a measure of stock market fundamentals and derive the bubble component. Koenig (2000) argues that unlike standard variables that enter monetary policy decision, productivity can have different implications. Moreover, this paper tries to estimate the extent of stock market volatility taking into account the asymmetries involved in stock returns variance. Then, this paper investigates the monetary policy response of the Fed vis-a-vis these three different components of the stock market. Robustness checks are done by using direct measures of productivity as well as using formal non-nested J tests (Davidson and MacKinnon, 1993) based on the encompassing principle of Richard and Mizon (1986) to show that the estimated reaction function outperforms rival models and appropriately characterizes the Fed Funds rate behavior in the presence of asset market developments.

III. MEASURING STOCK BUBBLES, FUNDAMENTALS AND VOLATILITY

Stock prices have the inherent characteristic of being volatile partly because they are driven by frequent revisions in market expectations. However, when volatility tends to be large there is a cause for concern and the question that arises is: To what extent do movements in stock prices represent changes in fundamental values? This section addresses this question by showing that stock prices may have a fundamental component driven by productivity growth as well as a bubble component (the so-called irrational exuberance part). If a change in asset prices is due to a change in market fundamentals this has very different implications for monetary policy response (as the study shows later) than if the change is because of a bubble.

The simple present value model which states that real stock prices depend linearly on real dividends is clearly inadequate. Indeed, Shiller (1981) shows that stock prices are too volatile to be explained by movements in dividends alone. Barsky and De Long (1993) and Campbell and Shiller (1987) also support this view that stock prices respond more than proportionately to movements in dividends. This suggests that stock prices tend to have another component besides fundamental values. In fact, West (1987) shows that the stock price equals the sum of two components: the price implied by the efficient markets model (Fama, 1970) and a speculative bubble. According to Stiglitz (1990), a stock price bubble exists if the reason that the price is high today is only because investors believe that the selling price will be high tomorrow. (5) Hence, bubbles represent price misalignments or deviations of stock market price from fundamental values.

Intrinsic Bubbles Model and Fundamental Values of Stocks