The (in)stability of stock returns and monetary policy interdependence in the US
Stock prices increases when the interest rate increases. The FOMC is not rasing the policy rate when stock prices increase.
We investigate the effects of monetary policy on equity returns and vice-versa in the US before, during and after the effective lower bound period (ELB) on interest rates. We use an inferential method in a (structural) VAR framework that exploits shifts in the volatility of shocks that affect equity returns and interest rates. Those shifts allow disentangling both effects without imposing restrictive assumptions previously used. We find dramatic changes in the relationship between monetary policy and equity returns over the period. Before the ELB period, policymakers reacted to increases in stock returns by raising the interest rate. This reaction becomes negative or muted since the ELB period. Regarding the stock market response to monetary policy, we find that a contractionary monetary policy that raises the policy rate decreases equity returns before the ELB period. Since then, however, we estimate that a rise in the policy rate increases returns, even after the ELB period. We show that this positive response of returns is driven by contractionary monetary policy lowering the expected equity premium.