Stock Prices, inflation and Monetary Policy

Tatom, John A.
October 2002
Business Economics;Oct2002, Vol. 37 Issue 4, p7
Academic Journal
Some analysts suggest that the Fed should target equity prices. This article questions this proposal on both theoretical and empirical grounds. There is a negative correlation between the fed funds rate and the price-earnings ratio, but it arises from a significant correlation of each measure with inflation. In the long run, stock prices are independent of the fed funds rate. The real fed funds rate is stationary. Cointegration evidence indicates a negative long-run relationship between stock prices and inflation, in turn implying that higher stock prices are associated with lower inflation and a lower fed funds rate, contrary to recent proposals. Taylor Rule estimates show that the Fed has implicitly acted on this well-founded relationship, exactly the opposite reaction that has been proposed recently. More important, such reactions take into account the correct indicator properties of stock prices, that they anticipate lower inflation, instead of acting as an independent cause of higher inflation.


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