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Inflation, monetary policy and stock market conditions: quantitative evidence from a hybrid latent-variable VAR

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  • Michael D. Bordo
  • Michael J. Dueker
  • David C. Wheelock

Abstract

This paper examines the association between inflation, monetary policy and U.S. stock market conditions during the second half of the 20th century. We use a latent-variable VAR to estimate the impact of inflation and other macroeconomic shocks on a latent index of stock market conditions. Our objective is to investigate the extent to which various shocks contribute to changes in market conditions, above and beyond their direct effects on real stock prices. We find that disinflation shocks promote market booms and inflation shocks contribute to busts. Further, we find that inflation shocks can explain more of the variation in real stock prices when stock market conditions are taken into account.

Suggested Citation

  • Michael D. Bordo & Michael J. Dueker & David C. Wheelock, 2009. "Inflation, monetary policy and stock market conditions: quantitative evidence from a hybrid latent-variable VAR," Working Papers 2008-012, Federal Reserve Bank of St. Louis.
  • Handle: RePEc:fip:fedlwp:2008-012
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    References listed on IDEAS

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    1. Ben S. Bernanke & Kenneth N. Kuttner, 2005. "What Explains the Stock Market's Reaction to Federal Reserve Policy?," Journal of Finance, American Finance Association, vol. 60(3), pages 1221-1257, June.
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    5. Michael Dueker, 2005. "Dynamic Forecasts of Qualitative Variables: A Qual VAR Model of U.S. Recessions," Journal of Business & Economic Statistics, American Statistical Association, vol. 23, pages 96-104, January.
    6. Fama, Eugene F, 1981. "Stock Returns, Real Activity, Inflation, and Money," American Economic Review, American Economic Association, vol. 71(4), pages 545-565, September.
    7. Fama, Eugene F. & Schwert, G. William, 1977. "Asset returns and inflation," Journal of Financial Economics, Elsevier, vol. 5(2), pages 115-146, November.
    8. Dueker, Michael & Nelson, Charles R., 2006. "Business-Cycle Filtering Of Macroeconomic Data Via A Latent Business-Cycle Index," Macroeconomic Dynamics, Cambridge University Press, vol. 10(05), pages 573-594, November.
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    13. Marc D. Hayford & A. G. Malliaris, 2005. "Monetary Policy And The U.S. Stock Market," World Scientific Book Chapters,in: Economic Uncertainty, Instabilities And Asset Bubbles Selected Essays, chapter 15, pages 233-247 World Scientific Publishing Co. Pte. Ltd..
    14. Michael D. Bordo & David C. Wheelock, 2007. "Stock market booms and monetary policy in the twentieth century," Review, Federal Reserve Bank of St. Louis, issue Mar, pages 91-122.
    15. Lee, Bong-Soo, 1992. " Causal Relations among Stock Returns, Interest Rates, Real Activity, and Inflation," Journal of Finance, American Finance Association, vol. 47(4), pages 1591-1603, September.
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    17. Philip Lowe & Claudio Borio, 2002. "Asset prices, financial and monetary stability: exploring the nexus," BIS Working Papers 114, Bank for International Settlements.
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    Keywords

    Inflation (Finance) ; Monetary policy ; Stock market;

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