EMPIRICAL EVIDENCE OF THE IMPACT OF FOMC MONETARY POLICY

ON THE U.S. EQUITY MARKET, 1990 - 2002

Jonas Neubauer
Department of Finance, Real Estate and Law
California State University, Long Beach

&

Khai Nguyen
Department of Finance, Real Estate and Law
California State University, Long Beach

Faculty Advisor: Jasmine Yur-Austin Ph.D.

 ABSTRACT

This study re-measures the sensitivity of indices returns to selected macroeconomic factors. The results show three most

influential factors – capacity utilization, consumer sentiment and depository reserves – are overall significantly priced as

sources of risk. Unlike previous studies, CPI and PPI are not useful in terms of predicting indices returns. Furthermore,

indices returns are mainly responding to the FOMC rate cuts than to rate hikes. In particular, NASDAQ is the index most

sensitive to rate cuts through the study period, 1990-2002. Finally, we show that different patterns of indices returns after

rate cuts during prime bull market (1995-1999) and recent bear market (2000-2002), respectively. Thus, the overall

results are consistent with the notion that the market situation, at least, partially affects the effectiveness of the Fed’s

monetary policy. (The conclusions of this study are based on FOMC Monetary Policy and relevant macroeconomic

factors from 1990 to 2002)

1. INTRODUCTION

The Federal Open Market Committee (hereafter, FOMC) has cut the interest rates eleven consecutive times in

2001 and one time in 2002. Starting the first cut in January, 2001 to the last cut in November, 2002, the Fed has cut a total

of 5.25%. Accordingly, the benchmark Federal funds rate has dropped to 1.25%, which is the lowest level since 1961.

Many economists, financial analysts, and investors are concerned whether such an aggressive monetary policy can

effectively revive the sluggish U.S. economy. In particular, the tragic events of September 11, 2001 and recent

geopolitical events (Iraq and North Korea) have made it more difficult to predict corporate earnings in any foreseeable

quarters. In light of many uncertainties involved in the current economic situation, the effectiveness of FOMC monetary

policy is facing unprecedented challenges.

Despite a total of twelve rate cuts in 2001 and 2002 along with an activation of tax cut in 2001, three major

market indexes DJIA, S&P 500, and NASDAQ have declined 12.38%, 17.12%, and 20.19%, respectively since the

beginning of 2002 (The returns of three major indices are calculated from January 01, 2002 to May 27, 2003). The

evidence suggests that the market shows a lukewarm response to the Fed’s rate-cut actions. Traditionally, it takes at least

six months to have the economy stimulated by a lower interest rate. Combined with the stimulus economy package, some

economists and financial analysts are optimistic about the prospects of the U.S. economy. However, facing with the

weakening labor market, the deteriorating corporate capital spending, the contracting manufacturing activities, the

declining U.S. dollar against Euro, and the rising budget deficit, other economists are cautious about the financial

soundness of the U.S. market. In regard to current economic news and equity market condition, it is important to know

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how long the U.S. economy remains stagnate. Is 2003 to be the year when industries show the sign of recovery? Will the

investors continuously maintain the healthy level of spending? Are there any catalysts to propel the indices to reach a

higher level? Most importantly, to what extent of securities returns are attributable to rate cuts initiated by the FOMC in

last two years?

We pursue three objectives in this study. First, in line with previous studies, we re-measure the implied equity

risk premium of selected macroeconomic factors. The second objective of this study is to identify which market index

benefits the most from the changes of interest rates from time to time. Further, we investigate whether securities returns

present asymmetric responses to rate hikes vs. rate cuts. Finally, we examine the impact of changes of monetary policy

on the equity market, measuring securities returns within twelve months after rate hikes (or rate cuts). In addition, the

effectiveness of FOMC monetary policy is tested in both prime bull market (1995-1999) and recent bear market (2000-

2002), respectively. The equity market provides an opportunity in which the investors make or lost trillions of dollars.

Therefore, the importance of the effectiveness of the FOMC monetary policy cannot be overlooked. The implications of

this study provide policy markers with detailed measurements about the impact of changes of monetary policy on the U.S.

economy. Additionally, the empirical findings of this study enable investors and funds’ managers to explore appropriate

timing of investment.

2. LITERATUR REVIEW

2.1 Changes of Monetary Policy and Possible Impacts on Securities Returns

Expanding their original sample to include utility, communication, nondepository financial firms, brokers-dealers,

and insurance firms, a later study suggests changes of reserve requirement carries little impact on equities returns outside

the banking industry (Hein and Stewart, 2002).

2.2 Relation Among Macroeconomic Factors

Prior studies document the negative correlation exists between the expected inflation rate and expected real rate

(Fama and Gibbons, 1982; Mishkin and Simon, 1995). But, a recent study adapts cointegration model to report that the

negative relation between expected real interest rate and expected inflation rate, in the long run, is not held in the U.S., the

U.K., and Canada (Shrestha, Chen and Lee, 2002).

2.3 Macroeconomic Factors and Securities Returns

A study done by (Domian, Gilster, and Louton, 1996) presents twelve months of excess stocks returns after the

drops in interest rates, while increases in interest rates have little impact on stocks returns. As for the money flow, the

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study reports if consumer spending increases, the major indices should follow as more money is circulated through the

markets and into the retained earnings of publicly traded companies (Otoo, 1999).

3. FOMC AND SELECTED MACROECONOMIC FACTORS

3.1 Brief Overview of FOMC Monetary Policy

The Federal Open Market Committee (as known FOMC) is the policy-making body of the United States Federal

Reserve, which is made up by twelve members. After reviewing recent reported economic data and discussing financial

conditions, FOMC determines the appropriate monetary policy, which tends to cultivate steady economic growth and to

foster long-run price stability. The monetary policy consists of three tools – open market operation, discount rate, and

reserve requirement - undertaken by the Federal Reserve to influence the liquidity of money and cost of borrowing in the

market. The Board of Governors of the Federal Reserve System decides the discount rate and reserve requirement, and

the FOMC is responsible for open market operation.

3.2 Macroeconomic Factors and Test Hypotheses

Monthly data of selected macroeconomic factors was taken from the Federal Reserve of St. Louis’ economic

research website. The chosen macroeconomic factors are CPI, PPI, capacity utilization, depository institution reserves,

and unemployment rate. (All factors are seasonally adjusted). We hypothesize the inverse relationship between changes in

CPI (PPI) and securities returns. High productivity definitely contributes toward the rising equity market between 1992

and 1995. Hence, we conjecture the higher capacity utilization results in higher indices returns, vice versa. As for

consumer spending, it has counted for two-thirds of economic activities. When people borrow more money to buy houses

or automobiles, bank (depository institution) reserves are reduced. Thus, we predict to have an inverse relation between

depository institution reserves and securities returns. Consumer sentiment describes a consumer’s willingness to spend.

Hence, a positive correlation between consumer sentiment and indices returns is expected. Rises in unemployment are

usually interpreted as a weight on the stock market. The data of the Federal fund rate is collected from FOMC.

4. EMPIRICAL MODEL AND EVIDENCE

4.1 Multiple-Factor Regression Model

The multiple-factor time-series regression model is adapted to ascertain whether selected macroeconomic factors

can explain variations of securities returns. In this study, we choose different indices to be the proxies of securities

returns. Monthly returns of DJIA, NASDAQ, S&P 500, Russell 3000, Value Line Index, and Philadelphia Gold and

Silver Index (XAU), from 1990 to 2002, are calculated.

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 R t = α + β1CPI t + β 2 PPI t + β 3 CU t + β 4 CS t + +β 5 DR t + β 6 UE t + ε t (1)

R t = α + β1 FOMC t ( Actual) + ε t (2)

where

Rt - the monthly returns of indices; CPIt - the monthly changes of CPI; PPIt - the monthly changes of PPI.

CUt -the monthly changes of capacity utilization; CSt - the monthly changes of consumer sentiment;

DRt - the monthly changes of depository reserves; UE - the monthly changes of unemployment rate;

FOMCt (actual) - actual hikes (or cuts) of the Fed rate; ε t - random error with mean zero.

4.2 Empirical Results and Interpretations (Tables are reported in the Reference)

Table 1 reports that all indices, except for few exceptions, have negative coefficients to CPI (and PPI). The

negative coefficient on CPI (and PPI) is consistent with our hypothesis. However, the overall t-stats are not significant.

On the other hand, the gold/silver index reacts positively to changes in PPI. The evidence supports our prior argument

that gold/silver is used as “hedging” investment to preserve the value of wealth when inflation is threat. To our surprise,

we do not find expected positive coefficient between indices returns and capacity utilization. One explanation to this

“anomaly” is that skillful workers with the help of advanced technology permits corporations manufacture same or greater

amount of goods at relatively lower capacity utilization. Likewise, the market indices report mixed results to changes in

unemployment rate.

The most important finding of our study is that all the indices (except for gold/silver index) statistically and

negatively respond to changes of depository reserves throughout the whole study period. This factor gives us a gage on

how much money consumers borrow and subsequently spend to facilitate the growth of economy. Hence, our empirical

evidence suggests that depository reserves is a better indicator than other chosen macroeconomic factors in an attempt to

predict securities returns. This result is also substantiated by positive regression results of consumer sentiment reported in

Table 1. Noticeably, the gold/silver index is negatively related to consumer sentiment. Taken together, higher consumer

sentiment leads to money moving out of precious metal back to equity market. Our results show that indices returns are

mainly responding to rate cuts rather than to rate hikes. Specifically, NASDAQ has largest coefficient of -8.98 responding

to a rate cut. Presumably, the changes of the Fed rate are expected to affect the equity market afterwards. Except gold &

silver index, Table 2 shows that both rate hikes and rate cuts seem to have positive effect on one –year indices returns

afterwards.

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 Accordingly, we tend to examine whether stocks returns within the post-rate changes period is affected by the

market conditions. Panel B of Table 3 reports rate cuts, however, fail to yield the positive effect in the recent bear market

from 2000 to 2002. Except for 28% gain in gold/silver index, other major indices suffer loss from -11% to -34%. The

evidence suggests the effectiveness of money policy has been diminished in bear market. Hence, we may argue that

investors are likely to think that the excessive measure is only taken when the economy is in its extremely worst stage.

Noticeably, gold/silver index reports an outstanding return of 28% after rate cuts over a period of 2000-2002 because

precious metal is viewed as a “safe heaven” during the economic downturn. Despite the tightening monetary policy

during prime bull market, rate hikes seem to have no adverse impact on equities returns. Such unusual phenomena may

be explained by the surging interest of investing in internet, telecom or other “high tech” speculative stocks. As a result,

the intent to combat inflation via higher rates has been undermined.

5. CONCLUSIONS

Since 1990, the FOMC has maintained its influence role via its maneuver of monetary policy. But, the recent

sluggish equity market starts casting doubt about the usefulness of the FOMC strategy. Would there be other

macroeconomic factors attributable to indices performance? Or would the monetary policy affect indices returns

differently in bull market vs. bear market?

We find contradictory results or little evidence that capacity utilization or unemployment rate are useful economic

factors in predicting securities returns. We also show that securities returns on average decrease as CPI and PPI increase

but the results are not significant. The gold/silver index presents a positive relationship as PPI increase, which is

consistent with our hypothesis of viewing precious metal as the “hedging” alternative to equity investment. The major

finding of our study is to report the significant and inverse relation between indices returns (excluding gold/silver index)

and depository reserves. The evidence suggests that lower depository reserves as a result of strong consumer spending

propel higher equity returns. Such finding is also validated by the positive response to increasing consumer sentiment,

which measures the consumers’ willingness to spend.

Moreover, this study documents that rate cut fails to yield the positive indices returns instead results in significant

loss from 2000 to 2002. This latter evidence suggests that the effectiveness of aggressive monetary policy is relatively

minimal during the recent bear market. Despite the Fed raises rates to curtail consumer spending, indices still present

positive returns within twelve months after rate hikes from 1995 to 1999. Thus, the overall results are consistent with the

notion that the market situation, at least, partially affects the effectiveness of the Fed’s monetary policy.

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 REFERENCES

Domian, Dale L., Gilster, John E., and Louton, David A., “Expected Inflation, Interest Rates, and Stock Returns”, The

Financial Review, 31, 1996, 809-830.

Fama, Eugene F. and Gibbons, Michael R., “Inflation, Real Returns, and Capital Investment”, Journal of Monetary

Economics, 9, 1982, 297-324.

Hein, Scott E., and Stewart, Jonathan D., “An Investigation of The Effect of The 1990 Reserve Requirement Changes of

Financial Asset Prices”, Journal of Financial Research, 25, 2002, 367-382.

Mishkin, Frederic. S., and Simon, John, “An Empirical Examination of The Fisher Effect in Australia”, The Economic

Record, 71, 1995, 217-229.

Otoo, Maria W., “Consumer Sentiment and The Stock Market”, Working Paper, 1999, 1-19.

Shrestha, Keshab, Chen, Sheng-Syan, and Lee, Cheng-Few, “Are Expected Inflation Rates and Expected Real Rates

Negatively Correlated? A Long-Run Test of The Mundell-Tobin Hypothesis”, Journal of Financial Research, 25,

2002, 305-320.

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 TABLE 1

Summary of Coefficients of Macroeconomic Factors

Monthly indices returns are regressed on monthly changes of CPI, PPI, CU (Capacity Utilization), CS (Consumer Sentiment), DR

(Depository Reserves), and UE (Unemployment Rate). The sample period is from 1990 to 20002. Estimated coefficients of each

macroeconomic factor are reported.

Major Indices
Macroeconomic DJIA S&P 500 NASDAQ Russell 3000 Value Line Gold/Silver

Factors
CPI -0.71 -0.78 -1.44 -0.90 0.07 -2.07
PPI -0.57 -0.16 1.49 -0.003 -0.29 0.93
CU -1.95** -1.83** -2.46* -1.83** -1.95** -1.79
CS 0.08 0.09 0.21 0.10 0.19** -0.09
** ** ** ** **
DR -0.30 -0.25 -0.57 -0.26 -0.37 0.05
UE -0.14 -0.15 -0.16 -0.14 -0.07 0.30
* Significant at 10% level. ** Significant at 5% level.

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 TABLE 2

Major Indices Returns Reponses to Rate Hikes and Rate Cuts

Monthly indices returns are regressed on actual changes of the Federal fund rate. The sample period is from 1990 to

20002. Estimated coefficients responding to changes of FOMC monetary policy are reported.

Major Indices
FOMC DJIA S&P 500 NASDAQ Russell 3000 Value Line Gold/Silver

Monetary Policy
Rate Hikes -1.58 -0.30 0.95 -0.40 -0.46 -2.07
* ** ** ** **
Rate Cuts -3.47 -4.91 -8.98 -5.06 -6.39 -2.24
* Significant at 10% level. ** Significant at 5% level.

TABLE 3

Twelve-Month Major Indices Returns Within Post Rate-Hikes / Rate-Cuts Period

Twelve-month indices returns are calculated for all the indices after each rate hike or rate cut. Three time periods are

studies – 1990-2002, 1995-1999, and 2000-2002, respectively.

Panel A: Twelve-month Major Indices Returns Within Post Rate-Hikes Period

Different Periods DJIA S&P 500 NASDAQ Russell 3000 Value Line Gold/Silver
1990-2002 15% 13% 17% 13% 6% -7%

1995-1999 25% 24% 36% 23% 14% 2%

(Bull Market)
2000-2002 -2% -7% -16% -6% -7% -17%

(Bear Market)

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 Panel B: Twelve-month Major Indices Returns Within Post Rate-Cuts Period
Different Periods DJIA S&P 500 NASDAQ Russell 3000 Value Line Gold/Silver
1990-2002 7% 4% 16% 6% 1% 7%

1995-1999 24% 21% 70% 20% 4% -6%

(Bull Market)
2000-2002 -11% -18% -34% -17% -19% 28%

(Bear Market)