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. In order to achieve identification we combine high frequency data on the S&P500 futures with the VAR methodology. Our empirical findings indicate: first, that monetary policy responds in a positive fashion to contemporaneous changes in the stock market; second, that stock returns respond negatively to a positive monetary policy shock and that both these responses are significant at 1% level. Our identification scheme uses weaker assumptions to address the problem of simultaneity and omitted variables that commonly affects this type of analysis. Besides a strong and significant reaction of stock market to policy innovations, results seems to confirm that when a more appropriate methodology is used, it is possible to detect a reaction of the Fed to asset prices in the conduct of monetary policy