Monetary policy rules and the equity risk premium: Evidence from the US experience

• Author: Nicholas Apergis,James E. Payne
• DOI: http://doi.org/10.1002/rfe.1021
• Published date: 01 October 2018
• Date: 01 October 2018

ORIGINAL ARTICLE

Monetary policy rules and the equity risk premium: Evidence

from the US experience

Nicholas Apergis

1

|

James E. Payne

2

1

Department of Banking and Financial

Management, University of Piraeus,

Piraeus, Greece

2

Office of Academic Affairs, Benedictine

University, Lisle, IL, USA

Correspondence

James E. Payne, Office of Academic

Affairs, Benedictine University, Lisle, IL,

USA.

Email: jpayne@ben.edu

Abstract

This study explores the role of monetary policy rules and central bank actions

originating from such rules that directly affects the equity risk premium. The

results indicate that monetary policy rules have a direct impact on the equity risk

premium through investors’appetite for risk and greater uncertainty faced by mar-

ket participants. The analysis includes the pre- and post-2008 financial crisis peri-

ods in finding that monetary policy actions had a much greater impact on the

equity risk premium in the post-2008 crisis period due in part to the funding con-

ditions of banking intermediaries, thus exerting a greater impact on credit condi-

tions during this period.

JEL CLASSIFICATION

G10, G12, E44

KEYWORDS

cointegration, equity premium, monetary policy rules

1

|

INTRODUCTION

Given the monetary policy transmission mechanism impacts the economy through the financial system, the link between

monetary policy and the financial system remains a topic of much discussion among policymakers and researchers . The

2008 financial crisis elevated the debate on the role that asset prices serve in monetary policy strategies to achieve both

price stability and output growth. There are some who claim that monetary policy should target asset prices and incorporate

some form of an asset price index into the definition of price stability. By contrast, others argue it is nearly impossible to

extract ‘fundamental’dynamics from asset prices in order to identify bubbles in real time along with the appropriate policy

response through the standard policy mechanism.

Indeed, one of the main lessons from the 2008 financial crisis is the monetary authorities cannot simply neglect asset

price developments, instead relying solely on their ability to intervene in the aftermath of a collapse. Bernanke and Kuttner

(2005) argue that equity prices move in response to new information about the easing or tightening of monetary policy

which is transmitted through fixed income yields to stock prices. We postulate that the equity market response to monetary

policy shocks does not necessarily operate via changes in yields, but more directly through changes in investors’risk per-

ception. In particular, this study emphasizes the role of the equity risk premium, that is, the difference betw een the return

on risky assets and risk-free assets, in explaining the mechanism through which monetary policy affects financial variables.

As noted by Tallarini (2000), the equity risk premium captures the welfare costs of recessions whereas the risk-free rate

determines the extent to which both households and firms are forward looking. Indeed, several studies have examined how

monetary policy could affect risk premia (Adrian & Liang, 2016; Adrian & Shin, 2010; Bekaert, Hoerova, & Duca, 2013;

Borio & Zhu, 2012; Drechsler, Savov, & Schnabl, 2018; Gertler & Karadi, 2015; Hanson & Stein, 2015; and Schmeling &

Wagner, 2016).

Received: 3 December 2017

|

Revised: 8 January 2018

|

Accepted: 27 January 2018

DOI: 10.1002/rfe.1021

Rev Financ Econ. 2018;36:287–299. wileyonlinelibrary.com/journal/rfe ©2018 The University of New Orleans

|

287