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This paper investigates the impact of monetary policy on stock returns in 13 OECD countries over the period 1972–2002. Our results indicate that monetary policy shifts significantly affect stock returns, thereby supporting the notion of monetary policy transmission via the stock market. Our contribution with respect to previous work is threefold. First, we show that our findings are robust to various alternative measures of stock returns. Second, our inferences are adjusted for the non-normality exhibited by the stock returns data. Finally, we take into account the increasing co-movement among international stock markets. The sensitivity analysis indicates that the results remain largely unchanged.

Monetary policy attempts to achieve a set of objectives that are expressed in terms of macroeconomic variables such as inflation, real output and employment. However, monetary policy actions such as changes in the central bank discount rate have at best an indirect effect on these variables and considerable lags are involved in the policy transmission mechanism. Broader financial markets though, for example the stock market, government and corporate bond markets, mortgage markets, foreign exchange markets, are quick to incorporate new information. Therefore, a more direct and immediate effect of changes in the monetary policy instruments may be identified using financial data. Identifying the link between monetary policy and financial asset prices is highly important to gain a better insight in the transmission mechanism of monetary policy, since changes in asset prices play a key role in several channels. In this paper, we provide empirical evidence on the relationship between monetary policy and one of the most important financial markets, the stock market. Stock prices are among the most closely monitored asset prices in the economy and are commonly regarded as being highly sensitive to economic conditions. In the context of the transmission mechanism through the stock market, monetary policy actions affect stock prices, which themselves are linked to the real economy through their influence on consumption spending (wealth effect channel) and investment spending (balance sheet channel).1 As Bernanke and Kuttner (2005) point out, some observers view the stock market as an independent source of macroeconomic volatility to which policymakers may wish to respond. Stock prices often exhibit pronounced volatility and boom–bust cycles leading to concerns about sustained deviations from their ‘fundamental’ values that, once corrected, may have significant adverse consequences for the broader economy. Hence, establishing quantitatively the existence of a stock market response to monetary policy changes will not only be germane to the study of stock market determinants but will also contribute to a deeper understanding of the conduct of monetary policy and of the potential economic impact of policy actions or inactions. According to the discounted cash flow model, stock prices are equal to the present value of expected future net cash flows. Monetary policy should then play an important role in determining equity returns either by altering the discount rate used by market participants or by influencing market participants’ expectations of future economic activity. These channels of influence are interlinked since more restrictive monetary policy usually implies both higher discount rates and lower future cash flows. Thus, monetary policy tightening should be associated with lower stock prices given the higher discount rate for the expected stream of cash flows and/or lower future economic activity. In contrast, an expansive monetary environment is commonly viewed as good news as these periods are usually associated with low interest rates, increases in economic activity and higher earnings for the firms in the economy. Consequently, stock market participants pay close attention to strategies based on the stance of the monetary authority as inferred by changes in indicators of central bank policy. Also, the financial press often interprets asset price movements as reaction to monetary policy shifts, attributing for instance increases in stock markets to low interest rates. Previous empirical evidence broadly supports the notion that restrictive (expansive) monetary policy decreases (increases) contemporaneous stock returns, as well as expected stock returns.2 These studies typically relate stock returns to measures of monetary policy stringency in the context of single equation specifications and/or multivariate Vector Autoregressions (VAR's). In this paper we take a closer look at the impact of monetary policy on stock returns by utilising 30 years of data across 13 OECD countries. Given the considerable debate on the relative merits of money aggregates during the late 1970s and early 1980s, we adopt the nowadays standard approach of measuring monetary policy using interest rate variables. We expand previous work by examining the sensitivity of our findings to the inclusion of dividend payments in the stock returns calculation, while considering both nominal and real returns. Our results indicate that for the majority of the countries under investigation the monetary environment is an important determinant of investors’ required returns. This holds across a variety of returns specifications (nominal, real, dividend adjusted, non-adjusted). We also examine the contemporaneous effect of monetary policy on stock returns taking into account the non-normality typically inherent in such data as well as the significant co-movement of international stock markets. The main result, that expansionary monetary policy boosts the stock market, remains largely robust in most sample countries. The implications of such findings for monetary policy making and investor portfolio formation are highly important. Central bankers and stock market participants should be aware of the relationship between monetary policy and stock market performance in order to better understand the effects of policy shifts. Monetary authorities in particular face the dilemma of whether to react to stock price movements, above and beyond the standard response to inflation and output developments. There is an ongoing debate in the monetary policy rules literature between the proactive and reactive approach. On the one hand, the proactive view advocates that monetary policymakers should alter interest rates in response to developing stock price bubbles in order to reduce overall macroeconomic volatility (see, e.g. Cecchetti, Genberg, Lipsky, & Wadhwani, 2000; Kontonikas & Ioannidis, 2005). On the other hand, according to the reactive approach, monetary authorities should wait and see whether the stock price reversal occurs, and if it does, to react accordingly to the extent that there are implications for inflation and output stability. Hence, the reactive approach is consistent with an accommodative ex post response to stock price changes (see Bernanke & Gertler, 1999; Bernanke & Gertler, 2001). Despite the difference in the timing of the reaction, both approaches effectively assume that the monetary authorities can affect stock market value. It is apparent then, that the empirical verification of this assumption is important for monetary policy formulation. The rest of the paper is organised as follows. The next section discusses the theoretical framework underlying the relationship between monetary policy and the stock market. Section 3 provides a short survey of the related vast empirical literature. Section 4 describes the data. Section 5 presents the empirical estimates of the impact of monetary policy changes on contemporaneous and expected stock returns, respectively. Section 6 provides conclusions and policy implications.

This paper examined the relationship between stock returns and monetary conditions in a sample of 13 OECD countries. The existence of such a relationship has important implications for both stock market participants and central bankers since, with respect to the former this issue relates to the broader topic of stock price determination and portfolio formation, while the latter are interested in whether monetary policy actions are transmitted through financial markets. Our proxies for shifts in monetary policy are based on interest rate variables including the change in the short-term Treasury Bill rate and a dummy variable reflecting discount rate changes. Our main contribution to the existing literature is that when we examine the impact of interest rate changes on stock price changes, we take into account the non-normal distribution of stock returns as well as the co-movement in international stock markets. The results suggest that in 80% of the countries under investigation, periods of tight money are associated with contemporaneous declines in stock market value. These findings can be understood in the context of the present value model, whereas interest rate increases are associated with lower stock prices via higher discount rates and lower future cash flows. Another important result is that following monetary policy changes, not only contemporaneous but also future stock returns, across a variety of returns specifications, are affected. Hence, our interest rate measure of monetary policy contains significant information that can be used to forecast expected stock returns. Specifically, we find that in most sample countries a restrictive monetary policy stance decreases expected stock returns. Such shifts in required returns do not necessarily contradict market efficiency since central banks often adopt expansive monetary policy when there is increased concern of an economic downturn. Hence, the finding that during these periods investors require higher returns to invest in the stock market may be a reasonable expectation after all. Our results imply that stock market investors should be aware of the international portfolio diversification opportunities across countries with different monetary environments. The implications of our findings for monetary policy formulation are profound, since we establish that central banks can affect stock market valuations by altering interest rates. This result broadly holds across a variety of countries that have adopted different monetary policy frameworks. These alternative policy regimes range from explicit inflation targeting (as practiced, e.g. in the UK, Sweden, Canada), to implicit targeting, where no formal targets are in place (as, e.g. in the US), and the two-pillar strategy of the ECB. Despite their operational differences, all these regimes focus on price stability as the primary monetary policy objective and they were successful since inflation has been largely contained for quite some time. Nevertheless, large fluctuations in stock prices during the late 1990s-early 2000 in an environment of stable consumer prices, the so-called ‘paradox of central bank credibility’, generated an intense debate in academic and policy circles regarding the appropriate monetary policy reaction to stock price movements. Notwithstanding that the two main competing views differ regarding the timing of the interest rate reaction to stock price misalignments (as early as possible, according to the proactive view; after the stock price reversal occurs, according to the reactive view), they both effectively assume that stock prices are sufficiently interest rate sensitive. In this paper, we did not attempt to answer the perennial question of whether monetary policy should respond to stock prices, this can be done only within a structural model, but rather took a step backwards and showed that the underlying assumption, that stock market valuations are affected by interest rate changes, is robust to close empirical inspection. Given this information, it is up to the monetary authority to calibrate the appropriate policy response to potential stock price misalignments.