FRBSF Economic Letter
2003-34; November 14, 2003
Should the Fed React to the Stock Market?
The late 1990s witnessed the emergence of the greatest speculative bubble
in financial market history. Investors bid up stock prices to unprecedented
valuation levels as they extrapolated a temporary surge in corporate earnings
growth far into the future. When these optimistic projections failed to
materialize, the bubble burst, setting off a chain of events that eventually
dragged the U.S. economy into a recession during 2001. In the aftermath
of these events, a much-debated question is whether U.S. monetary policy
should have reacted more aggressively to the parabolic run-up in stock
prices. It has been argued that a policy of "leaning against the
bubble" could have spared the economy from the long and painful process
of unwinding bubble-induced excesses. This Economic Letter examines
the issue of whether central banks should react directly to asset prices.
In addition, it presents empirical evidence which shows that lagged movements
in the Standard & Poors (S&P) 500 stock index can help explain
movements in the U.S. federal funds rate since 1987.
Asset prices and the economy
Changes in the prices of assets, such as stocks or houses, can have important
consequences for the economy. During the late 1990s, consumers became
wealthier as their stock portfolios appreciated. This "wealth effect"
boosted personal consumption expenditures, which account for about two-thirds
of GDP. Rapidly rising stock prices also helped fuel a boom in business
investment by lowering firms' cost of capital. Surging tax collections
from investors' capital gains realizations allowed governments at all
levels to increase spending or cut taxes. More recently, rising house
prices, together with innovations in mortgage lending, have allowed consumers
to tap the equity in their homes to pay for a variety of goods and services.
Through these channels and others, increases in asset prices may cause
demand growth to outstrip potential increases in supply, thus contributing
to inflationary pressure.
Central banks' goals are to keep inflation low while promoting sustainable
real growth. Given that swings in asset prices can affect both goals,
some economists have argued that central banks can improve macroeconomic
performance by responding directly to asset prices. Based on simulations
from a small economic model, Cecchetti, et al. (2000) conclude that performance
can be improved if the central bank raises the short-term nominal interest
rate in response to temporary "bubble shocks" that push the
stock price index above the value implied by economic fundamentals. Bernanke
and Gertler (2001) reach a different conclusion; they allow "fundamental
shocks" (such as a technological innovation that raises productivity
and profits) to also be a source of movement in stock prices. They assume
that the central bank cannot tell whether an increase in stock prices
is driven by a bubble shock or a fundamental shock. Since both types of
shocks ultimately affect real output and inflation, they conclude that
the central bank can do just as well by responding only to those goal
variables; they find no significant additional benefit to responding directly
to stock prices.
A limitation of the above models is the assumption that asset price bubbles
randomly inflate and burst regardless of any central bank action. Hence
these models cannot address the important questions of whether a central
bank should try to prevent bubbles from forming or whether a central bank
should try to deflate a bubble once it has formed.
Costs of ignoring bubbles
Advocates of preventing stock market bubbles point out that bubbles can
distort economic and financial decisions, creating costly imbalances that
can take years to dissipate. During the late 1990s, surging market values
for technology-related companies led many firms to vastly overspend on
computers, networking equipment, and software, at the expense of other
items. It is now clear that a portion of that technology capital was never
put into productive service. This wasteful spending was nevertheless counted
in real output statistics, thus contributing to overestimates of the economy's
trend growth rate. The overhang of the excess capital acquired during
the bubble has contributed to low levels of capacity utilization and a
sluggish rebound in business investment relative to the average recovery
(see Lansing 2003).
The stock market bubble distorted other areas of the U.S. economy as
well. Firms hired large numbers of permanent employees to satisfy an episode
of demand growth that was not sustainable. When the bubble burst, demand
growth slowed and firms had to lay off employees. Now, two years after
the recession's official end-date in November 2001, labor market weakness
persists. The rapid appreciation of stocks held in employee pension plans
led many firms to reduce cash contributions to their plans, which made
reported earnings look better. When stock prices dropped, the value of
plan assets shrank, contributing to an underfunding problem in excess
of $200 billion among S&P 500 companies (see Kwan 2003). Foreign investors'
eagerness to participate in the booming U.S. stock market of the late
1990s drove up the value of the dollar on foreign exchange markets, contributing
to a dramatic expansion of the U.S. current account deficit. The deficit
now exceeds 5% of GDP, implying that the U.S. economy must draw in about
$1.5 billion per day from foreign investors to finance domestic spending.
Finally, the collapse in capital gains tax revenues after the bubble burst
has forced elected officials to make difficult and unpopular choices to
address the resulting budget shortfalls.
Can bubbles be identified?
Despite the many problems propagated by bubbles, some have argued that
central banks should ignore bubbles. Their argument consists of two parts:
(1) central banks cannot reliably determine if a run-up in stock prices
is actually a bubble until after it has burst; (2) an interest rate hike
of sufficient magnitude to prick a suspected bubble would likely send
the economy into a recession, thereby sacrificing the benefits of the
boom that might otherwise continue.
To identify a bubble in real time, policymakers would need to judge whether
a valuation metric, such as the price-earnings (P/E) ratio for the aggregate
stock market, has crossed into bubble territory. But rendering such a
judgment may be difficult in practice, particularly if the bubble is triggered
by investor overreaction to an actual fundamental improvement in the underlying
economy. For example, a pickup in measured productivity growth during
the late 1990s appeared to offer to some fundamental justification for
the rise in the market P/E ratio. Others have countered that the difficulties
in identifying bubbles do not justify ignoring them altogether. Central
banks routinely apply judgment to a whole host of issues affecting monetary
policy. One example is the size of the so-called "output gap,"
defined as the difference between actual GDP and potential GDP. The output
gap is notoriously difficult to measure in real time, yet it remains an
important input to central bank inflation forecasts.
Regarding the second part of the argument, some worry that a policy designed
to prick an emerging bubble could have unintended negative consequences.
Opponents of bubble-popping often cite the example of the Great Depression,
claiming it was exacerbated by the Fed's overzealous attempts to rein
in speculative stock market excesses. A counterargument is provided by
Borio and Lowe (2002), who perform an exhaustive historical study of financial
market bubbles in many countries. According to the authors, opponents
of bubble-popping fail to take sufficient account of the asymmetric nature
of the costs of policy errors when faced with a suspected bubble: "If
the economy is indeed robust and the boom is sustainable, actions by the
authorities to restrain the boom are unlikely to derail it altogether.
By contrast, failure to act could have much more damaging consequences,
as the imbalances unravel" (p. 26). They also argue that emerging
bubbles can be more readily identified if central banks look beyond asset
prices to include other variables that signal a threat to financial stability.
Specifically, they find that episodes of sustained rapid credit expansion,
booming stock or house prices, and high levels of investment, are almost
always followed by periods of stress in the financial system.
Empirical evidence
Clearly, economists have yet to reach a consensus on whether central
banks should react directly to asset prices. But what do central banks
actually do? Interestingly, empirical evidence suggests that U.S. monetary
policy has reacted directly to the stock market during the term of Federal
Reserve Chairman Alan Greenspan.
Figure 1 plots an estimated Fed policy rule using quarterly data over
the period 1987:Q3 to 2003:Q3. The estimated rule is constructed along
the lines of the well-known "Taylor rule." Specifically, the
quarterly average federal funds rate is regressed on a constant term,
the inflation rate in the previous quarter (as measured by the four-quarter
percent change in the GDP price index), and the output gap in the previous
quarter (as measured by the percent deviation of real GDP from a fitted
long-run trend).
Figure 2 adds the annualized percent change in the S&P 500 stock
index during the previous quarter to the regression equation. The use
of data from the previous quarter helps ensure that the direction of causation
runs from the stock market to the funds rate, and not vice versa. Including
the stock market variable significantly improves the empirical fit of
the estimated policy rule. This is most notable toward the end of the
data sample, when the actual federal funds rate dropped from 6.5% in 2000:Q4
to 1.0% in 2003:Q3. During this time, the S&P 500 index lost nearly
one-third of its value. The above results reinforce the findings of Rigobon
and Sack (2003), who employ high frequency data on stock market movements
and interest rate changes from 1985 to 2000. They find that a 5% decrease
(increase) in the S&P 500 over the course of a week raises the probability
of a 25-basis-point interest rate cut (hike) by 64%.
While the data indicate that the Fed reacts directly to the stock market,
statistical regressions do not reveal the motives behind this behavior.
One possibility is that forward-looking policymakers view movements in
the stock market as useful predictors of future economic activity. Another
possibility is that policymakers act out of concern for market valuation.
In an effort to divine the Fed's motives, Hayford and Malliaris (2001)
studied Federal Open Market Committee (FOMC) transcripts during Greenspan's
term. The authors conclude that FOMC members paid significant attention
to the valuation of the stock market and that, on some occasions, concerns
about the stock market directly influenced the conduct of U.S. monetary
policy. In one notable instance (February 1994), the transcripts suggest
that FOMC members were worried that raising the funds rate by 50 basis
points might trigger a crash in the stock market, which was thought to
be overvalued at the time. In this case, the stock market's possible reaction
appeared to act as a constraint on policymakers' desire to tighten policy
against the threat of rising inflation.
Conclusion
Although central banks control only short-term interest rates, their
ability to influence longer-term rates and other asset prices is part
of the transmission mechanism of monetary policy. Movements in asset prices
can have important consequences for real output and inflation. Still,
economists do not agree on whether central banks should react directly
to asset prices, or, more specifically, whether central banks should take
steps to prevent or deflate asset price bubbles. The arguments against
doing so emphasize issues pertaining to difficulty and risk, but there
are strong counterarguments that favor action when faced with a suspected
bubble.
Kevin J. Lansing
Senior Economist
References
[URLs accessed November 2003.]
Bernanke, B., and M. Gertler. 2001. "Should
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http://www.frbsf.org/publications/economics/letter/2003/el2003-16.html
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http://www.frbsf.org/publications/economics/letter/2003/el2003-17.html
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