Stock Returns and Monetary Policy: Are There Any Ties?

Abstract

This paper empirically investigates the following three questions: (i) Do stock returns respond to monetary policy shocks? (ii) Do stock returns alter the transmission mechanism of monetary policy? and (iii) Does monetary policy systematically react to stock returns? Existing research based on event studies and Structural Vector Auto-Regressions (SVAR) documents that stock returns increase significantly following an unanticipated monetary policy expansion. However, this literature did not explore whether or not stock returns matter for the choice of monetary policy or its propagation mechanism. In this paper, we use a SVAR that relaxes the restrictions commonly imposed in earlier studies and identify monetary policy shocks by exploiting the conditional heteroscedasticity of the structural innovations. Applying this method to U.S. data, we reach a surprising and puzzling conclusion: the answers to the three questions above are No, No, and No!