If Central banker raises/lowers interest rates how do stock markets react? Do they go up or down? This question is of immense interest to most.
Bernanke and Kuttner had written a very useful paper on the issue in 2003. As paper is time consuming Bernanke had explained the findings (in English) in his speech in 2003. It is 2007 now and there could be some changes in the results in terms of numbers but I would guess the trend would be similar.
Bernanke explains that it is important to distinguish between expected and unexpected changes in interest rates (the fed funds rate) . If the actual change is as the market expects, then financial markets would have already priced the change, but if it is unexpected (i.e. markets expect a 25 bps cut and Fed announces a 50 bps increase) then the impact can be best measured.
So, for example, on November 6, 2002, the Federal Reserve cut the federal funds rate by 50 basis points. (A basis point equals 1/100 of a percentage point, so a 50-basis-point cut equals a cut of 1/2 percentage point.)
However, this cut in the federal funds rate was not entirely unexpected; indeed, according to the federal funds futures market, investors were expecting a cut of about 31 basis points, on average, from the Fed at that meeting.
So, of the 50 basis points that the FOMC lowered its target for the federal funds rate last November 6, only 19 basis points were a surprise to financial markets and thus should have been expected to affect asset prices. Note, by the way, that if the Fed had not changed interest rates at all that day, our method would have treated that action as the equivalent of a surprise tightening of policy of 31 basis points because the Fed would have done nothing while the market was expecting an easing of 31 basis points.
And what were the results? They find that the stock price multiplier for monetary policy is about 4.7 which means if there is a rate cut of 25 bps or 0.25% then stock market is likely to move up by 125 bps or 1.25%.
However, if certain extreme events like when stock markets increased by 5% etc due to rate cut, the stock price multiplier is 2.6.
Now, what accounts for this rise in stock prices? Bernanke says there are three broad channels why stock prices change:
- First, news that current or future dividends will be higher should raise stock prices.
- Second, news that current or future real short-term interest rates will be higher should lower stock prices.
- And third, news that leads investors to demand a higher risk premium on stocks should lower stock prices
Which factor is more responsible?
What we actually found when conducting this statistical experiment was quite interesting. It appears that, for example, an unanticipated tightening of monetary policy leads to only a modest change in forecasts of future dividends and to still less of a change in forecasts of future real interest rates (beyond a few quarters). Quantitatively, according to our methodology, the most important effect of a policy tightening is on the forecasted risk premium
Why risk rises when monetary policy is tightened?
….Tighter monetary policy may raise the riskiness of shares themselves by raising the interest costs and weakening the balance sheets of publicly owned firms. In the macroeconomy more generally, by reducing spending and economic activity, tighter money raises the risks of unemployment or bankruptcy faced by individual households or firms.
Lessons for Mon Pol:
1) Easy Mon Pol (i.e lowering the rates) leads to higher stock prices
2) But mon pol is not very effective for controlling stock prices as the change in stock prices due to changes in mon pol is very small.
This is a wow speech and is highly recommended. It is a la Bernanke. I however still wonder why he cut rates by 50 bps?