IT HAS BEEN OF GREAT interest to both macroeconomists and financial economists of whether monetary policy affects stock returns. A number of studies have empirically investigated the effects of monetary policy on stock returns. Using money aggregate data as a measure of money supply, some empirical studies agree that stock returns lag behind changes in monetary policy; for instance, see Keran (1971), Homa and Jaffee (1971), and Hamburner and Kochin (1972). In contrast, Cooper (1974), Pesando (1974), Rozeff (1974), and Rogalski and Vinso (1977) show that there is no significant forecasting power of past changes in money. Ever since the seminal paper by Bernanke and Blinder (1992), the Federal funds rate has been the most widely used measure of monetary policy. As such, the relationship between monetary policy and stock returns has been reexamined by using the interest rate instrument in the financial literature. Thorbecke (1997) and Patelis (1997) demonstrate that shifts in monetary policy help to explain U.S. stock returns. Conover, Jensen, and Johnson (1999) show that foreign stock returns generally react both to local and U.S. monetary policy.
Two important contributions to the literature on the effects of monetary policy on the stock market have been made. The first one emphasizes the roles of financial markets’ expectations about the future course of monetary policy. Bernanke and Kuttner (2003) extract unanticipated monetary policy from Federal funds futures and find that monetary policy surprises appear to have a significant effect on equity prices through changes in the equity premium. The second focus is on the prospect of endogeneity. Rigobon and Sack (2003) show that the causality between interest rates and stock prices may run in both directions. After accounting for this endogeneity, they find a significant monetary policy response to the stock market.
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