What If the Fed Increased the Weight of the Stock Price Gap in its Reaction Function?

The Fed has never admitted targeting stock prices. Yet our empirical analysis, based on a small macro-econometric model of the U.S. economy in the period 1981-2002, shows that the Fed explicitly takes into account stock price variations in its reaction function. Furthermore, our simulation results suggest that increasing the weight attributed to stock price changes could prove advisable, as the stock market wealth effect increases. This measure would help to contain the additional instability brought about by this economic evolution, and confirm the current political trend towards protecting stock owners