The Fed and Stock Market: A Proxy and Instrumental Variable Identification

Stock market fluctuations are likely to be an important determinant of monetary policy decisions because of their potential impact on macroeconomy. At the same time, innovations in fed fund rates affect stock prices as they change the expected future real interest rates. In this paper we apply a new identification procedure, based on proxy and IV variables, to estimate the contemporaneous relations between stock market and monetary policy without imposing any exclusion restrictions on the parameters of interest. Our empirical results indicate: first, that monetary policy responds in a positive fashion to contemporaneous changes in the stock market, but this relationship is not significant; second, that stock returns respond negatively to a positive monetary policy shock and that this response is significant at 1% level. This estimation analysis, while indicating that stock market participants react strongly and significantly to monetary policy innovations, seems to confirm the fact that in the past the Fed has not directly targeted asset prices in the conduct of monetary policy.