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The paper examines whether shifts in the stance of monetary
policy can account for the observed predictability in excess
stock returns. Using regressions, the paper concludes that
monetary policy variables are significant predictors of future
returns, though they cannot fully account for observed stock
return predictability. I undertake variance decompositions to
investigate how monetary policy affects the individual
components of excess returns.
The sample period extends from January 1982 to December 1996,
and conclusions are as follows:
Monetary policy represents a significant portion of the
explanation forasset returns predictability-but only a portion,
not the whole. The particularposition of monetary policy is not
adequately captured by the monetary variables used in the
analysis; thus additional financial variables have additional
forecasting power.
Variance decompositions indicate that federal fund rate,
monetary policy, shocks primarily affect expected excess
returns, followed by termspread, but have little effect on
dividend yield.
Monetary policy shocks affect the risk structure of the exonomy,
and also the risk characteristics of stocks. Assets such as
equities are claims onfuture economic output, so if monetary
policy has real economic effect, thenshifts in monetary policy
should affect stock prices.
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