Stocks Can Get It Up Just Fine Without The Fed, Thank You Very Much

The stimulative effects on the stock market of abnormally low interest rates may be greatly exaggerated.
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Since the crisis, financial media commentators have periodically asserted that the Federal Reserve’s actions were the driving force behind rising stock prices. The view that the Fed is the reason stock prices are so high also appears to be popular among retail investors. The common refrain has been that the Fed kept interest rates artificially low to help boost stocks.

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To test this view, two colleagues and I examined stock prices in relation to interest rates in the US and abroad between 1971 and 2016. This type of study is difficult because of the myriad factors than can affect both stocks and interest rates. In particular, external factors that cause a higher interest rate such as a strong economy may also cause stronger stock returns. Similarly, a high unemployment rate that leads the Fed to lower interest rates may be associated with lower stock returns.

To account for this, we examined interest rates through the lens of their deviation from the Taylor Rule. The Taylor Rule is a mathematical formula created by Stanford economist John Taylor which proscribes what interest rates should be given inflation and GDP growth in the economy.

By offering a straightforward, quantitative method of calculating what interest rates “should” be at any point in time, the Taylor Rule removes the possibility of human error or the benefit of human judgement from the interest rate decision. The difference between the actual discount rate and the Taylor Rule’s recommendation is a proxy for Fed influence.

We also went a step further and looked at interest rates outside the US and stock returns internationally. When examining international stock returns, we used international interest rates and modified the Taylor Rule formula to pertain to the country in question. The countries examined for this study include the US, Canada, Great Britain, Germany, and Australia.

So what did we find? Is the Fed the reason that stocks are so highly valued?

The answer – based on statistical evidence – is a resounding no.

Our results show that the Fed has at most a modest impact on stock returns. In particular, while the Fed’s discount rate is correlated to S&P 500 stock returns, this effect is likely driven by outside factors. The Taylor Rule residuals have a correlation with S&P 500 returns of negative 0.05, suggesting that if anything, greater levels of unorthodox Fed policies are associated with lower stock returns. This is the opposite of the story that many commentators have claimed.

We also used a series of regressions that detail the relationship between stock prices and current and past Taylor Rule residuals to test the idea that the Fed is influencing stock prices. Here, there is a strong and statistically significant negative relationship between Taylor Rule residuals from two months prior and current month S&P 500 returns. Those results show that a one percent change in the discount rate that is not justified under the Taylor rule leads to a 33.6 to 35.6 basis point fall in average stock returns. While this effect is statistically significant, it is of only modest economic significance in comparison to average annual stock returns that are on the order of 11% over the last 90 years.

S&P returns plotted against the differential between Taylor Rule values and the federal funds rate. (Mike McDonald)

S&P returns plotted against the differential between Taylor Rule values and the federal funds rate. (Mike McDonald)

The international results suggest a strong positive relationship between Taylor Rule residuals and stock returns in all four nations. In other words, while there is a limited but negative relationship between Fed “interference” and stock returns in the US, outside of the country, central bank “interference” helps to bolster stocks.

We are still exploring the discrepancy between central bank impacts in the US versus other countries, but one explanation for our results is that US markets respond differently to central bank policies because of differences in stock market development. For example, US markets may be more forward looking and may incorporate likely Fed actions before they occur in a way that other markets around the world do not.

Despite what market commentators would have us believe, there is no reliable evidence that the Fed is fully responsible for current stock price levels. The Fed undoubtedly influences the stock market though its impact on the broader US economy, but it is not reasonable to see the Fed as somehow “tampering” with the stock market outside of its normal mandate.

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