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The Fed's Effect on Excess Returns and Inflation is Much Bigger Than You Think

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Author Info
Shingo Goto (Anderson School of Management)
Abstract

We find that between 20 and 25 percent of the negative covariance between excess returns and inflation is explained by shocks to monetary policy variables. The finding is robust to changes in the monetary policy rule that have occured during the 1966-1998 period. The result contradicts the theory that money supply shocks induce a positive correlation between inflation and returns. Our findings also cast doubt on models that explain the negative correlation in a money-neutral environment (Boudoukh, Richardson, and Whitelaw (1994)), and on models that account for this correlation as being due solely to money demand shocks (Fama (1981), Marshall (1992)). We argue that contractionary monetary policy lowers excess stock market returns through various channels. Furthermore, if the Fed has some private information about future inflation, then a contractionary monetary shock will be followed by an increase in inflation, in the short run. The combined effect is a negative inflation/excess returns correlation. The results lend support to the argument that if asset pricing models are to capture the observed negative correlation, they must incorprate monetary policy effects.

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Paper provided by Anderson Graduate School of Management, UCLA in its series University of California at Los Angeles, Anderson Graduate School of Management with number 1058.

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Date of creation: 05 May 2000
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Handle: RePEc:cdl:anderf:1058

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Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Leeper, Eric M. & Gordon, David B., 1992. "In search of the liquidity effect," Journal of Monetary Economics, Elsevier, vol. 29(3), pages 341-369, June. [Downloadable!] (restricted)
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  2. Oliner, Stephen D & Rudebusch, Glenn D, 1996. "Monetary Policy and Credit Conditions: Evidence from the Composition of External Finance: Comment," American Economic Review, American Economic Association, vol. 86(1), pages 300-309, March. [Downloadable!] (restricted)
  3. Lastrapes, William D, 1989. "Exchange Rate Volatility and U.S. Monetary Policy: An ARCH Application," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 21(1), pages 66-77, February. [Downloadable!] (restricted)
  4. Bernanke, Ben & Gertler, Mark & Gilchrist, Simon, 1996. "The Financial Accelerator and the Flight to Quality," The Review of Economics and Statistics, MIT Press, vol. 78(1), pages 1-15, February. [Downloadable!] (restricted)
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  5. Eric M. Leeper & Christopher A. Sims & Tao Zha, 1996. "What Does Monetary Policy Do?," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 27(1996-2), pages 1-78. [Downloadable!]
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  1. Ben S. Bernanke & Kenneth N. Kuttner, 2003. "What explains the stock market's reaction to Federal Reserve policy?," Staff Reports 174, Federal Reserve Bank of New York. [Downloadable!]
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  2. Pedro Santa-Clara & Rossen Valkanov, 2000. "Political Cycles and the Stock Market," University of California at Los Angeles, Anderson Graduate School of Management 1074, Anderson Graduate School of Management, UCLA. [Downloadable!]
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