Monetary policy, stock returns, and the role of credit in the transmission of monetary policy.

AuthorThorbecke, Willem
  1. Introduction

    What causes business cycle fluctuations? Do they arise from real factors such as productivity shocks and taste changes, or do nominal factors such as changes in monetary policy also matter? If monetary factors affect real variables, what are the channels transmitting policy changes to the economy? This paper addresses these questions by examining the response of stock returns to monetary policy shocks and other macroeconomic variables. It finds that these common factors explain a substantial portion of the variation in stock returns, indicating that economic fluctuations are not due to real factors alone. It also finds that disinflationary monetary policy harms both small and large firms while expansionary policy benefits large but not small firms. These results have mixed implications for the view that one channel of monetary transmission occurs through its impact of bank loans and on firms' balance sheets. These findings also indicate that small firms bear a greater burden than large firms from changes in monetary policy.

    Previous researchers have uncovered evidence that monetary policy and other macroeconomic variables affect the real economy. Bernanke and Blinder [3], using Granger causality tests and variance decompositions from a VAR, have shown that innovations in the funds rate over the 1959:7-1989:12 period forecasted industrial production, unemployment, and other real variables well. Romer and Romer [20], using a narrative approach, have documented six episodes over the postwar period when anti-inflationary monetary policy was followed by increases in unemployment and declines in industrial production. Gali [12], using a VAR methodology, finds that money supply shocks over the 1955:Q1-1987:Q3 period explain 13 percent of output variability at a five-to ten- quarter horizon.

    Stockman [24] used a different tack to test real models of economic fluctuations against those emphasizing the real effects of monetary, fiscal, and other macroeconomic variables. He investigated the fraction of the variation in industrial production growth that was due to industry-specific shocks and to nation-specific shocks. He reasoned that in real business cycle models, industry-specific shocks should be more important than nation-specific shocks. On the other hand, in models emphasizing the real effects of monetary and other macroeconomic policies, nation-specific shocks should be more important than industry-specific shocks. Using a variance components technique and panel data from eight OECD countries, he found that both industry-specific and nation-specific shocks are empirically important. Thus he concluded that technology or taste changes alone do not explain most macroeconomic fluctuations.(1)

    The evidence supporting monetary business cycle models has been accompanied by research investigating whether monetary policy matters in part because of its influence on bank loans and on firms' balance sheets. Bernanke and Blinder [2] have shown in an IS-LM model that if bonds and bank loans are imperfect substitutes, then an open market sale by the Federal Reserve that decreases reserves will also decrease loans. If certain firms have difficulty obtaining credit from other sources, then the reduction in bank loans will lower capital investment and aggregate demand. Gertler and Gilchrist [15] have discussed how a monetary tightening, by increasing interest rates, can worsen cash flow net of interest and thus firms' balance sheet positions. If firms prefer internal finance to external finance, then the diminished liquidity will lower investment and aggregate demand.

    Gertler and Gilchrist have argued that smaller firms are more likely to be constrained in their access to credit. They are more likely to obtain funds from banks than from equity, bonds, or commercial paper. They are less likely to be well collateralized. Building on this insight, Gertler and Gilchrist [15] and Christiano, Eichenbaum, and Evans [8] have investigated whether small and large firms respond differently to monetary policy shocks. Gertler and Gilchrist found that sales and inventory investment fall substantially more for small firms than for large firms following a monetary contraction. Gertler and Gilchrist and Christiano, Eichenbaum, and Evans found that total borrowing and bank loans by small firms decrease following a monetary tightening while total borrowing and bank loans by large firms increase. These results are consistent with the view that monetary policy affects real variables in part because of its influence on bank loans and on firms' balance sheets. These results are also of independent interest, as Bernanke [1] has argued, because they imply that small firms bear a disproportionate burden from disinflationary monetary policy.

    Gertler and Gilchrist [15, 313] make clear that they are investigating the variability of small firms that is correlated with common factors, not that which is due to "idiosyncratic risk". Another way of examining this is through the use of multi-factor asset pricing models (e.g., Ross [21] and Cox, Ingersoll, and Ross [10]). In these models, assets must pay risk premia to compensate for their exposures to common factors but not for their exposures to idiosyncratic risks. As developed by Ross [21], excess returns [R.sub.i] - [[Lambda].sub.0] in a multi-factor framework can be written:

    [R.sub.i] - [[Lambda].sub.0] = [[Sigma].sub.j][[Beta].sub.ij][[Lambda].sub.j] + [[Sigma].sub.j][[Beta].sub.ij][f.sub.j] + [[Epsilon].sub.i] (1)

    where [R.sub.i] is the return on asset i, [[Lambda].sub.0] is the risk-free rate, [[Beta].sub.ij] is the exposure of asset i to macroeconomic variable j, [[Lambda].sub.j] is the risk premium associated with factor j, [f.sub.j] is the unexpected change in macroeconomic variable j, and [[Epsilon].sub.i] is a mean-zero error term. The expression [[Sigma].sub.j][[Beta].sub.ij][[Lambda].sub.j] represents the expected return on asset i, [[Sigma].sub.j][[Beta].sub.ij][f.sub.j] represents the systematic component of the unexpected return, and [[Epsilon].sub.i] represents the idiosyncratic component of the unexpected return.

    There are several advantages to using stock return data to infer whether monetary policy matters and if so why. First, it enables us to learn the dynamic effects of monetary policy on firm performance. Theory posits that stock prices equal the expected present value of firms' future payouts. As Shapiro [22] has noted, these payouts ultimately must reflect economic activity, implying that industry stock prices should be related to future real activity in that industry. Black [4] has similarly argued that an increase in stock prices in a sector more often than not presages an increase in sales, earnings, and capital outlays in that sector. Thus examining how monetary policy innovations affect industry stock returns can shed light on how monetary shocks affect industry output. Second, stock returns are useful for achieving the decomposition discussed by Stockman [24]. The first two expressions on the right side of (1) represent the effects of macroeconomic factors on asset returns while the third expression captures the effects of industry-specific factors. Third, by using stock returns for large and small firms, one can gauge the relative effects of monetary policy shocks on large and small firms. This in turn sheds light on whether monetary policy affects real variables because of the influence of monetary policy on bank loans and on firm balance sheets.

    Using a nonlinear seemingly unrelated regression technique and asset returns on 39 portfolios we find that innovations in monetary policy and other macroeconomic variables explain on average 32 percent of the variation in stock returns. These findings indicate that models relying on industry-specific productivity shocks or taste changes leading to sectoral reallocations are not sufficient to explain business fluctuations. We also find that in 96 percent of the cases examined a monetary tightening depresses stock prices. This result supports...

To continue reading

Request your trial

VLEX uses login cookies to provide you with a better browsing experience. If you click on 'Accept' or continue browsing this site we consider that you accept our cookie policy. ACCEPT