ByJames Bullard , Charles M. Hokayem
During the 1990s, stock price movements were extraordinary. At the beginning of 1994, the Dow Jones Industrial Average (DJIA) was about 3,800; as of this writing (February 2002), the DJIA hovers around 10,000 but is down about 1,000 points from the peaks that occurred during late 1999 and early 2000. These movements have sparked a great deal of discussion among policy-makers, academic economists and the financial press about the role the stock market should play in influencing monetary policy decisions.
During the recent stock-market gyrations, there has been resurgent interest in rules that monetary policy-makers can follow when they adjust short-term nominal interest rates. These rules, based on the work of Taylor (1993), typically call for the Fed to adjust the intended federal funds rate in response to two factors: (1) the deviation of inflation from a target rate of inflation, and (2) the performance of the real economy relative to a historical benchmark. Taylor argued that such a rule would best keep inflation low and stable, and simultaneously keep the economy on a steady growth path.
All the recent attention on the stock market and on monetary policy rules has inspired a natural question: Should the Fed also react to equity price movements when it makes monetary policy decisions? Some analysts have argued that such a reaction sometimes occurs. For example, the federal funds rate declined in 2001 as the returns on the DJIA fell. This episode along with some of the history can be seen in the chart, which plots the federal funds rate and the percentage change in the DJIA from 1990 to 2001.
We suggest that the Fed not react to equity price developments because it would be similar to looking in a mirror. Stock market prices already reflect the actions the Fed is taking to influence inflation and output. Here's why:
Let's begin with the idea that investors expect to get the same returns from bonds as they do from stocks—once one takes into account that stocks tend to be riskier. For our purposes, let's assume that the risk premium for stocks is unchanging over time. If expected bond returns change up or down, then investors will reallocate their portfolios between stocks and bonds until their expected returns—net of risk—are again equal.
Because bond prices are connected with short-term nominal interest rates, whenever the Fed changes short-term nominal interest rates, bond prices also change. Likewise, when bond prices change, so do stock prices. In other words, Fed policy changes cause a readjustment in all asset prices: short-term interest rates, bond prices and equity prices. Therefore, to turn around and argue that the Fed should react (again) to changing stock prices is somewhat circular.
One might ask, "What would happen if the level of equity prices were included in a Taylor-type monetary policy rule?" To keep equity prices relatively constant, the discussion given above suggests that nominal interest rates should not move at all. But this conflicts with the basic idea behind the Taylor rule, which calls for movements in nominal interest rates to stabilize output and inflation.
In summary, if policy-makers include equity prices in the policy rule, it will only interfere with the Fed's job of stabilizing inflation and output. This is why we think the Fed should ignore the stock market when making decisions about monetary policy.
Taylor, John B. "Discretion vs. Policy Rules in Practice." Carnegie-Rochester Conference Series on Public Policy, 1993, 39, pp. 195-214.