Stock Prices, Inflation and Monetary Policy

Some analysts suggest that the Fed should target equity prices. This article questions this proposal on both theoretical and empirical grounds. There is a negative correlation between the fed funds rate and the price-earnings ratio, but it arises from a significant correlation of each measure with i...

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Bibliographic Details
Published in:Business economics (Cleveland, Ohio) Ohio), 2002-10, Vol.37 (4), p.7-19
Main Author: Tatom, John A.
Format: Article
Language:English
Subjects:
Business economics
Causality
Central banks
Cointegration analysis
Consumer spending
Consumption
Economic inflation
Economic theory
Equity
Federal funding
Federal funds
Federal funds rate
Federal Reserve Bank
Inflation
Inflation rates
Monetary policy
Prices
Stock markets
Stock prices
Studies
Time series
Wealth effect
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Summary:Some analysts suggest that the Fed should target equity prices. This article questions this proposal on both theoretical and empirical grounds. There is a negative correlation between the fed funds rate and the price-earnings ratio, but it arises from a significant correlation of each measure with inflation. In the long run, stock prices are independent of the fed funds rate. The real fed funds rate is stationary. Cointegration evidence indicates a negative long-run relationship between stock prices and inflation, in turn implying that higher stock prices are associated with lower inflation and a lower fed funds rate, contrary to recent proposals. Taylor Rule estimates show that the Fed has implicitly acted on this well-founded relationship, exactly the opposite reaction that has been proposed recently. More important, such reactions take into account the correct indicator properties of stock prices, that they anticipate lower inflation, instead of acting as an independent cause of higher inflation.
ISSN:0007-666X
1554-432X