Monetary policy and financial market developments in the US

Zekaite, Zivile (2017) Monetary policy and financial market developments in the US. PhD thesis, University of Glasgow.

Abstract

Over the past decade, monetary policy has been in the spotlight as one of the key
drivers of the real economy due to its aggressive response to the global financial crisis of
2007 - 2009. This has revived the debate of the late 1990s regarding the role of asset prices
in policy decision making and has renewed interest in the impact of monetary policy on
financial markets. Therefore, the focus of this thesis is the relationship between monetary
policy conduct and financial market developments in the United States (US) over the
period spanning the Great Moderation, the global financial crisis and its aftermath. Three
empirical chapters analyse different aspects of monetary policy interaction with financial
markets using alternative methodologies.
The first empirical chapter provides a comprehensive study of conventional
monetary policy in the US. It investigates the Federal Reserve’s response to financial
market stress during the Great Moderation and the part of the global financial crisis by
addressing two main questions. Firstly, does the Federal Reserve (Fed) react directly to the
indicators of financial stress and, if so, is such reaction symmetric? Secondly, does the
policy response to inflation and output gap change in light of financial turmoil? These
questions are examined with respect to the four different dimensions of financial market
stress: credit risk, stock market liquidity risk, stock market bear conditions and poor
overall financial conditions. In addition, the analysis separately evaluates the impact of the
latest crisis on US monetary policy. The results indicate the direct policy reaction to
developments in the stock market price index, an interest rate spread, the measure of stock
market liquidity and broad financial conditions that is found to be strongly dependent on
the business cycle. Financial market developments have much more weight on the Fed’s
decisions during economic recessions as compared to economic expansions. Furthermore,
in times of elevated financial distress, the Fed’s reaction to inflation declines to some
extent, while the output gap parameter becomes statistically insignificant. Nevertheless, the
finding that financial stress implies a lower policy rate appears to be largely driven by
monetary policy actions during the period 2007 - 2008. Thus, the financial crisis has had
important implications for US monetary policy.
Chapter 2 investigates what explains the variation in unexpected excess returns on
the 2-, 5- and 10-year Treasury bonds and how returns respond to conventional and
unconventional monetary policy in the period spanning the Great Moderation, the recent
financial crisis and its aftermath. In addition, unexpected excess returns are decomposed
into three components related to the revisions in rational market expectations (news) about
future excess returns, inflation and real interest rates to identify the sources of the bond
market response to monetary policy. The main findings imply that news about future
inflation is the key factor in explaining the variability of unexpected excess Treasury bond
returns across the maturities. Regarding the effect of conventional and unconventional
monetary policy actions, monetary easing is generally associated with higher unexpected
excess Treasury bond returns. Furthermore, the results highlight the importance of the
inflation news component in explaining the reaction of the bond market to monetary
policy. The positive effect of monetary easing on unexpected excess Treasury bond returns
is largely explained by the corresponding negative effect on inflation expectations.
Nevertheless, the bond market reaction to conventional policy shocks has grown weaker
over the more recent period, perhaps reflecting changes in the implementation and
communication of the Fed’s policy since the middle 1990s. Meanwhile, the results with
respect to unconventional monetary policy are driven to a great extent by the peak of the
financial crisis in autumn of 2008.
Finally, Chapter 3 aims to revisit the role of conventional Fed’s policy in
explaining the size and value stock return anomalies, while taking fully into account the bidirectional
relationship between monetary policy and real stock prices. As interest rate-based
policy is of main interest here, the sample period ends prior to the crisis in 2007. The
results confirm a strong, negative and significant monetary policy tightening effect on real
stock prices at both aggregate and disaggregate (portfolio) levels. Furthermore, there is the
evidence of the “delayed size effect” of monetary policy actions. Following a
contractionary monetary policy shock, an immediate decline in stock prices of large firms
is more pronounced as compared to small firms. However, large stocks recover to a great
extent in the second period after the shock, while small stocks drop sharply. Meanwhile,
the findings overall are not very supportive of the differential impact of monetary policy on
value versus growth stocks as predicted by the credit channel. Finally, the results do not
indicate the strong Fed’s reaction to stock price developments.

• Item Type: Thesis (PhD)
• Qualification Level: Doctoral
• Keywords: Monetary policy, asset prices, monetary policy rule, financial stress.
• Subjects: H Social Sciences > H Social Sciences (General); H Social Sciences > HB Economic Theory; H Social Sciences > HG Finance
• Colleges/Schools: College of Social Sciences > Adam Smith Business School > Economics
• Supervisor's Name: Kontonikas, Professor Alexandros and Nolan, Professor Charles
• Date of Award: 2017
• Depositing User: Ms Zivile Zekaite
• Unique ID: glathesis:2017-8150
• Copyright: Copyright of this thesis is held by the author.
• Date Deposited: 23 May 2017 08:55
• Last Modified: 09 Jun 2017 07:47
• URI: https://theses.gla.ac.uk/id/eprint/8150