Inflation, Monetary Policy and Stock Market Conditions: Quantitative Evidence from a Hybrid Latent-Variable VAR

Abstract

This paper examines the association between inflation, monetary policy and U.S. stock market conditions during the second half of the 20th century. We use a latent-variable VAR to estimate the impact of inflation and other macroeconomic shocks on a latent index of stock market conditions. Our objective is to investigate the extent to which various shocks contribute to changes in market conditions, above and beyond their direct effects on real stock prices. We find that disinflation shocks promote market booms and inflation shocks contribute to busts. Further, we find that inflation shocks can explain more of the variation in real stock prices when stock market conditions are taken into account.

Keywords: Stock market conditions, booms, busts, monetary policy, inflation, Qual-VAR

JEL Classification: E31, E52, G12, N12, N22