Should the Fed React to the Stock Market?

The late 1990s witnessed the emergence of the greatest speculative bubble in financial market history. Investors bid up stock prices to unprecedented valuation levels as they extrapolated a temporary surge in corporate earnings growth far into the future. When these optimistic projections failed to materialize, the bubble burst, setting off a chain of events that eventually dragged the U.S. economy into a recession during 2001. In the aftermath of these events, a much-debated question is whether U.S. monetary policy should have reacted more aggressively to the parabolic run-up in stock prices. It has been argued that a policy of "leaning against the bubble" could have spared the economy from the long and painful process of unwinding bubble-induced excesses. This Economic Letter examines the issue of whether central banks should react directly to asset prices. In addition, it presents empirical evidence which shows that lagged movements in the Standard & Poors (S&P) 500 stock index can help explain movements in the U.S. federal funds rate since 1987.

Changes in the prices of assets, such as stocks or houses, can have important consequences for the economy. During the late 1990s, consumers became wealthier as their stock portfolios appreciated. This "wealth effect" boosted personal consumption expenditures, which account for about two-thirds of GDP. Rapidly rising stock prices also helped fuel a boom in business investment by lowering firms' cost of capital. Surging tax collections from investors' capital gains realizations allowed governments at all levels to increase spending or cut taxes. More recently, rising house prices, together with innovations in mortgage lending, have allowed consumers to tap the equity in their homes to pay for a variety of goods and services. Through these channels and others, increases in asset prices may cause demand growth to outstrip potential increases in supply, thus contributing to inflationary pressure.

Central banks' goals are to keep inflation low while promoting sustainable real growth. Given that swings in asset prices can affect both goals, some economists have argued that central banks can improve macroeconomic performance by responding directly to asset prices. Based on simulations from a small economic model, Cecchetti, et al. (2000) conclude that performance can be improved if the central bank raises the short-term nominal interest rate in response to temporary "bubble shocks" that push the stock price index above the value implied by economic fundamentals. Bernanke and Gertler (2001) reach a different conclusion; they allow "fundamental shocks" (such as a technological innovation that raises productivity and profits) to also be a source of movement in stock prices. They assume that the central bank cannot tell whether an increase in stock prices is driven by a bubble shock or a fundamental shock. Since both types of shocks ultimately affect real output and inflation, they conclude that the central bank can do just as well by responding only to those goal variables; they find no significant additional benefit to responding directly to stock prices.

A limitation of the above models is the assumption that asset price bubbles randomly inflate and burst regardless of any central bank action. Hence these models cannot address the important questions of whether a central bank should try to prevent bubbles from forming or whether a central bank should try to deflate a bubble once it has formed.

Advocates of preventing stock market bubbles point out that bubbles can distort economic and financial decisions, creating costly imbalances that can take years to dissipate. During the late 1990s, surging market values for technology-related companies led many firms to vastly overspend on computers, networking equipment, and software, at the expense of other items. It is now clear that a portion of that technology capital was never put into productive service. This wasteful spending was nevertheless counted in real output statistics, thus contributing to overestimates of the economy's trend growth rate. The overhang of the excess capital acquired during the bubble has contributed to low levels of capacity utilization and a sluggish rebound in business investment relative to the average recovery (see Lansing 2003).

The stock market bubble distorted other areas of the U.S. economy as well. Firms hired large numbers of permanent employees to satisfy an episode of demand growth that was not sustainable. When the bubble burst, demand growth slowed and firms had to lay off employees. Now, two years after the recession's official end-date in November 2001, labor market weakness persists. The rapid appreciation of stocks held in employee pension plans led many firms to reduce cash contributions to their plans, which made reported earnings look better. When stock prices dropped, the value of plan assets shrank, contributing to an underfunding problem in excess of $200 billion among S&P 500 companies (see Kwan 2003). Foreign investors' eagerness to participate in the booming U.S. stock market of the late 1990s drove up the value of the dollar on foreign exchange markets, contributing to a dramatic expansion of the U.S. current account deficit. The deficit now exceeds 5% of GDP, implying that the U.S. economy must draw in about $1.5 billion per day from foreign investors to finance domestic spending. Finally, the collapse in capital gains tax revenues after the bubble burst has forced elected officials to make difficult and unpopular choices to address the resulting budget shortfalls.

Despite the many problems propagated by bubbles, some have argued that central banks should ignore bubbles. Their argument consists of two parts: (1) central banks cannot reliably determine if a run-up in stock prices is actually a bubble until after it has burst; (2) an interest rate hike of sufficient magnitude to prick a suspected bubble would likely send the economy into a recession, thereby sacrificing the benefits of the boom that might otherwise continue.

To identify a bubble in real time, policymakers would need to judge whether a valuation metric, such as the price-earnings (P/E) ratio for the aggregate stock market, has crossed into bubble territory. But rendering such a judgment may be difficult in practice, particularly if the bubble is triggered by investor overreaction to an actual fundamental improvement in the underlying economy. For example, a pickup in measured productivity growth during the late 1990s appeared to offer to some fundamental justification for the rise in the market P/E ratio. Others have countered that the difficulties in identifying bubbles do not justify ignoring them altogether. Central banks routinely apply judgment to a whole host of issues affecting monetary policy. One example is the size of the so-called "output gap," defined as the difference between actual GDP and potential GDP. The output gap is notoriously difficult to measure in real time, yet it remains an important input to central bank inflation forecasts.

Regarding the second part of the argument, some worry that a policy designed to prick an emerging bubble could have unintended negative consequences. Opponents of bubble-popping often cite the example of the Great Depression, claiming it was exacerbated by the Fed's overzealous attempts to rein in speculative stock market excesses. A counterargument is provided by Borio and Lowe (2002), who perform an exhaustive historical study of financial market bubbles in many countries. According to the authors, opponents of bubble-popping fail to take sufficient account of the asymmetric nature of the costs of policy errors when faced with a suspected bubble: "If the economy is indeed robust and the boom is sustainable, actions by the authorities to restrain the boom are unlikely to derail it altogether. By contrast, failure to act could have much more damaging consequences, as the imbalances unravel" (p. 26). They also argue that emerging bubbles can be more readily identified if central banks look beyond asset prices to include other variables that signal a threat to financial stability. Specifically, they find that episodes of sustained rapid credit expansion, booming stock or house prices, and high levels of investment, are almost always followed by periods of stress in the financial system.

Clearly, economists have yet to reach a consensus on whether central banks should react directly to asset prices. But what do central banks actually do? Interestingly, empirical evidence suggests that U.S. monetary policy has reacted directly to the stock market during the term of Federal Reserve Chairman Alan Greenspan.

Figure 1 plots an estimated Fed policy rule using quarterly data over the period 1987:Q3 to 2003:Q3. The estimated rule is constructed along the lines of the well-known "Taylor rule." Specifically, the quarterly average federal funds rate is regressed on a constant term, the inflation rate in the previous quarter (as measured by the four-quarter percent change in the GDP price index), and the output gap in the previous quarter (as measured by the percent deviation of real GDP from a fitted long-run trend).

Figure 2 adds the annualized percent change in the S&P 500 stock index during the previous quarter to the regression equation. The use of data from the previous quarter helps ensure that the direction of causation runs from the stock market to the funds rate, and not vice versa. Including the stock market variable significantly improves the empirical fit of the estimated policy rule. This is most notable toward the end of the data sample, when the actual federal funds rate dropped from 6.5% in 2000:Q4 to 1.0% in 2003:Q3. During this time, the S&P 500 index lost nearly one-third of its value. The above results reinforce the findings of Rigobon and Sack (2003), who employ high frequency data on stock market movements and interest rate changes from 1985 to 2000. They find that a 5% decrease (increase) in the S&P 500 over the course of a week raises the probability of a 25-basis-point interest rate cut (hike) by 64%.

While the data indicate that the Fed reacts directly to the stock market, statistical regressions do not reveal the motives behind this behavior. One possibility is that forward-looking policymakers view movements in the stock market as useful predictors of future economic activity. Another possibility is that policymakers act out of concern for market valuation. In an effort to divine the Fed's motives, Hayford and Malliaris (2001) studied Federal Open Market Committee (FOMC) transcripts during Greenspan's term. The authors conclude that FOMC members paid significant attention to the valuation of the stock market and that, on some occasions, concerns about the stock market directly influenced the conduct of U.S. monetary policy. In one notable instance (February 1994), the transcripts suggest that FOMC members were worried that raising the funds rate by 50 basis points might trigger a crash in the stock market, which was thought to be overvalued at the time. In this case, the stock market's possible reaction appeared to act as a constraint on policymakers' desire to tighten policy against the threat of rising inflation.

Although central banks control only short-term interest rates, their ability to influence longer-term rates and other asset prices is part of the transmission mechanism of monetary policy. Movements in asset prices can have important consequences for real output and inflation. Still, economists do not agree on whether central banks should react directly to asset prices, or, more specifically, whether central banks should take steps to prevent or deflate asset price bubbles. The arguments against doing so emphasize issues pertaining to difficulty and risk, but there are strong counterarguments that favor action when faced with a suspected bubble.

Bernanke, B., and M. Gertler. 2001. "Should Central Banks Respond to Movements in Asset Prices?" American Economic Review 91, pp. 253-257.

Hayford, M.D., and A.G. Malliaris. 2001. "Is the Federal Reserve Stock Market Bubble-Neutral?" In Asset Price Bubbles: Implications for Monetary and Regulatory Policies, ed. G.C. Kaufman. Elsevier Science Ltd., pp. 229-243.

Kwan, S. 2003. "Underfunding of Private Pension Plans." FRBSF Economic Letter 2003-16 (June 13).
http://www.frbsf.org/publications/economics/letter/2003/el2003-16.html

Lansing, K.J. 2003. "Growth in the Post-Bubble Economy." FRBSF Economic Letter, 2003-17 (June 24).
http://www.frbsf.org/publications/economics/letter/2003/el2003-17.html

Rigobon, R., and B. Sack. 2003. "Measuring the Reaction of Monetary Policy to the Stock Market." Quarterly Journal of Economics 118, pp. 639-670.

Socialism would not be possible without the Federal Reserve. Inflation would not be possible without the Federal Reserve or something comparable. Government is not the root of all evil; politicians are. By default, government is corrupt and evil since government is run by politicians.

I would ask precisely how and why you think government can be responsible for the police functions of society when politicians and government are themselves inherently corrupt?

The Constitution does not permit government to control or regulate money beyond its coining function. "Coining" does not include printing. Intrastate banking does not put "The Fed" in the picture at all. How can the US avoid either bankruptcy or hyperinflation as long as "The Fed" has control of our money and credit?

If you believe the answer is anything other than we can't, you are mistaken. And if you believe that it is not going to happen before the middle of the next decade, you have not read the Gokhale-Smetters Report.

The Federal Reserve is an interesting institution. If I understand it correctly, it decides how much money to print, where it goes and sets interest rates. This appears to me to be massive central control of the money, sort of like the how the former Soviet Union operated in controlling how many houses were built, the number of cars, manufacturing size 12 shoes in March and size 11 in April.

It all looks so....soviet.

I wonder how Americans would feel if we had a Federal Bread Board. It would decide how many loaves would be baked each day, whole wheat, white or rye and where it would be distributed and at what price.

Well, what do I know other than those fiat notes in my pocket buy less and less each year.

"Assuming we are stuck with fiat money.."

That is precisely the question we should be addressing. Why should we assume that we are stuck with fiat currency? Why should we continue to allow government to steal our savings through inflation? Why should we allow government and other debtors to partially default through inflation? Why should we continue to allow government to penalize other non-investing productive and wise citizens through fraudulent insurance programs that simply monetize failed or foolish investments? I am specifically referring to FSLIC, FDIC, flood insurance, and the myriad host of government sponsored insurance programs that make the government into the largest insurance company on the planet.

There is a by-product issue to this question. Most of the myriad regulatory agencies and the huge burden of regulation that permeates our country are based on conditions required to meet insurability under the government insurance schemes. Want your regulatory burden lowered? Get government out of the insurance business.

"I believe in unemployment "insurance" as a government controlled rainy day fund.."

Why?

Is there some place in the Constitution that says I should insure you against job loss and further why I should support you while you can't seem to find a job? Most of my working life was spent as a self-employed person. I paid "unemployment insurnce" premiums to government for as many as 25 employees who worked for me, but until I incorporated and became an employee myself was not eligible to participate. But I carried a substantial disability policy through a private insurance company to cover the contingency in case I couldn't work.

There is nothing that precludes private insurance companies from providing "unemployment insurance" to any worker who might want to purchase "job insurance". The reason you don't see such policies is because the government charges premiums substantially below real market rates and the premiums are well below true market risks. Government loses money on every one of its insurance programs. Federally insured, means the under funded losses are all monetized. It is unconstitutional. It is pure socialism. It is corrupt. Without fiat currency, socialism cannot exist. If conservatives want to break the back of socialism, all we need to do is stop accepting fiat currency as payment for goods and services.

"Un-employment-an interesting question in itself!"

Have you ever asked your self why people can be unemployed? Look around your own workplace. Are there tasks that are undone or uncompleted? Are that tasks that could be done that are not even on the list of things to do or that should be done? Look around America. Are there things that you see that should be done or that need doing? Why aren't these things happening? Why isn't unfulfilled demand being met? Is there any task that could or should be done that anybody can do, but nobody is doing it? Are there any people that are not capable of doing something productive, but yet these people are not doing anything?

Government is the only cause of unemployment. Find anybody that can prove me wrong!

I understand that unemployment insurance taxes are socialist. The reason I advocate them is not going to sound good to people who see the misuse of fiat money as the cause of economic cycles. Some are indeed triggered by monetary policy and some are made worse by it. But the root cause of economic cycles is psychology. Overinvestment and overproduction are formed from inexact market measurements particularly of competitors. If I open a widget factory and don't know that you are opening a widget factory (and vv) then our economy will have "too many" widget factories.

In that context unemployment insurance taxes merely cut back on some economic growth (we both hire fewer widget makers) in order to allow some widget makers to maintain their consumptive spending in a downturn. Rather than a short but serious downturn we end up with longer but less disruptive downturns. The social value is that rather than move to find new work, the unemployed widget makers can weather the downturn while maintaining family and community ties.

"The social value is that rather than move to find new work, the unemployed widget makers can weather the downturn while maintaining family and community ties."

Read that sentence carefully. I fail to see any value. And if there is a value, then private insurance can fill that value more efficiently and more appropriately than government.

As for the question of over investment or over production, the reason entrepenuers make more and larger errors is access to capital and artificial demand. Inflation of the money supply by government and too much credit creation fostered by government through the federal reserve increase the misallocation of capital. No one knows what the business cycle would actually look like without government interference in the free market because it has never been tried. But no one can misallocate resources or disturb the allocation of resources to a greater extent than government. Free markets are going to be much closer to a true and proper equilibrium than any other method of allocating resources simply because the largest possible number of participants will be involved in the decisions. And the decision makers will be making those decisions with fewer distractions caused by changes in the supply of money or credit. More decisions, less noise, fewer mistakes and the magnitude of each mistake will be predictably less; by definition, the frequency of the business cyle will be longer and the amplitude less. Most of the adversity of the business cycle is caused by government, not business. And the corrections will be simpler, easier and more beneficial. Entrepnuers will be more likely to learn from their mistakes and from the mistakes of others, but only if someone suffers the consequences of those mistakes. Perhaps you have not considered why people keep repeating the same mistakes. How else can the same people keep going bankrupt, but continue to keep finding sources of capital?

Banks that can fail will be a lot more cautious about lending to you to build widgets in a free market economy where you, your employees and the bank itself can all fail without recourse from anybody. And you will be a lot more careful about building wiget factories when you are using your own money as opposed to "OPM". I suggest you spend some time reading Murray Rothbard on the free downloads availabe from mises.org.

Read that sentence carefully. I fail to see any value. And if there is a value, then private insurance can fill that value more efficiently and more appropriately than government.

You don't value community ties? You would rather see the unemployed uprooted and moved each time there is an economic disruption? Children separated from aging parents instead of staying to take care of them?

The greatest efficiency would come from community support in downturns, but what happens when the entire community gets hit with a plant closing?

As for the question of over investment or over production, the reason entrepenuers make more and larger errors is access to capital and artificial demand. That's just one reason.

Inflation of the money supply by government and too much credit creation fostered by government through the federal reserve increase the misallocation of capital. No one knows what the business cycle would actually look like without government interference in the free market because it has never been tried. But no one can misallocate resources or disturb the allocation of resources to a greater extent than government. I agree along with occasional contractions of the money supply causing artificial capital shortages.

Free markets are going to be much closer to a true and proper equilibrium than any other method of allocating resources simply because the largest possible number of participants will be involved in the decisions. And the decision makers will be making those decisions with fewer distractions caused by changes in the supply of money or credit. More decisions, less noise, fewer mistakes and the magnitude of each mistake will be predictably less; by definition, the frequency of the business cyle will be longer and the amplitude less. Most of the adversity of the business cycle is caused by government, not business. And the corrections will be simpler, easier and more beneficial.

There's no denying that the business cycle would be subdued if the government didn't mess with the money supply. But that doesn't change the fact that the business cycle is subdued by unemployment insurance taxes. By taxing employment, the decisions of the decision makers are being skewed towards less hiring during booms. During contractions, the unemployment payouts cause fewer people to become unemployed from ripple effect.

Independent individuals learn to stand on their own feet or at least on the foundation of family. Would you go to the neighbor that lives next door to you and tell them you have lost your job and would they be willing to help support you for the next 180 days?

My children work hard and long hours, but are barely sustaining themselves. As unemployment is presently configured and administered by government, the working successful workers are penalized by bad businesses or marginal employees. This is classic liberalism; punish success for the benefit of failures.

Your thinking is an embarrassment to freedom.

Would you go to the neighbor that lives next door to you and tell them you have lost your job and would they be willing to help support you for the next 180 days?

I would and they would help the best they could. I consider them good neighbors and try to be one myself.

This is classic liberalism; punish success for the benefit of failures. Your thinking is an embarrassment to freedom

That's a canard. Unemployment insurance does not simply reward failure although it can do that. Likewise paying the tax will "punish" success to a minor extent, although the social benefit of reducing the spread of recession through ripple effect reduces that "punishment" somewhat. Ok, my answer is a canard too.

I presume common defense justifies forfeiting some freedom. "Security" is ill-defined and probably has little to do with real security (protection from people who take lives or property). I agree it's not worth giving up freedom (e.g. 4th amendment) for such security (e.g. catch criminals more easily).

On the economic side, I think it's a tougher call. Some property is already taken for the common defense. Penalizing success through unemployment tax is the same necessary evil with some redistribution aspects (not a good thing) and some smoothing of economy over regions and over time (which I consider a good thing). Furthermore, the country's manufacturing base has defense value and is often hit harder in economic cycles because it is physical. Preserving that work force to some extent helps the country survive over the long run.

You are a hopeless socialist. And you are wrong.

Government compulsion is the antithesis of freedom. A vote for compulsory unemployment insurance is one step into slavery. After you have taken the first step, history says you will end up a slave. Then there are only two questions that matter: How long will it take before you realize you are a slave? Will someone else fight for their freedom and free you in the process?

If there were no minimum wage and no department of labor, there would be no unemployment. History says your own government is the single greatest threat to your own security. Like the frog, you are being boiled alive and haven't realized it.

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