The Fed's Effect on Excess Returns and Inflation is Much Bigger than You Think

32 Pages Posted: 11 Apr 2002

See all articles by Shingo Goto

Shingo Goto

University of Rhode Island - College of Business Administration

Rossen I. Valkanov

University of California, San Diego (UCSD) - Rady School of Management

Date Written: March 2002

Abstract

We find that between 20 and 25 percent of the negative covariance between excess returns and inflation is explained by shocks to monetary policy variables. The finding is robust to changes in the monetary policy rule that have occurred during the 1966-2000 period. The result contradicts the theory that money supply shocks induce a positive correlation between inflation and returns. Our findings also cast doubt on models that explain the negative correlation in a money-neutral environment (Boudoukh, Richardson, And Whitelaw (1994)), and on models that account for this correlation as being due solely to money demand shocks (Fama (1981), Marshall (1992)). We argue that contractionary monetary policy lowers excess stock market returns through various channels. Furthermore, if fed shocks raise the borrowing costs of firms or if the fed has some private information about future inflation, then a contractionary monetary shock will be followed by an increase in inflation, in the short run. The combined effect is a negative inflation/excess returns correlation. The results lend support to the argument that if asset pricing models are to capture the observed negative correlation, they must incorporate monetary policy effects.

JEL Classification: G10, G12, E44, E51, E61, C32

Suggested Citation

Goto, Shingo and Valkanov, Rossen, The Fed's Effect on Excess Returns and Inflation is Much Bigger than You Think (March 2002). Available at SSRN: https://ssrn.com/abstract=307133 or http://dx.doi.org/10.2139/ssrn.307133

Shingo Goto (Contact Author)

University of Rhode Island - College of Business Administration ( email )

Kingston, RI 02881
United States
4018744318 (Phone)
4018744312 (Fax)

Rossen Valkanov

University of California, San Diego (UCSD) - Rady School of Management ( email )

9500 Gilman Drive
Rady School of Management
La Jolla, CA 92093
United States
858-534-0898 (Phone)

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