Financial markets are an essential component of an economy. With the virtual disappearance of borders preventing free flow of capital across nations, its implications not only affect a country’s economic growth but also the country’s ability to raise capital to meet its investment requirements. Financial markets, in this respects, covers the whole range of financial assets, companies and their products. The market participants involved may include those dealing in the derivatives markets, venture capitalists, foreign exchange dealers, hedge funds, investment banks, stock brokers, and financial credit agencies.

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Considering this diversified interest groups, it is essential that we have certain control regime to regulate this complex markets. Unlike other sectors such as Service and Manufacturing, the financial markets are essentially more sensitive to market behaviour and trends. Note that this does not in any sense mean that service or manufacturing sector is any less influential than the financial sector on economic growth.

In recent times, we have observed that trends in financial markets in one country can influence the behaviour of these markets elsewhere. This integration and interdependence of the world financial market has brought about increased necessity for interest rate parity to prevent capital from moving frantically from one economy or sector to another. Federal banks in conjunction with their respective governments introduce reforms and regulations to control capital movements in and out of the country. These reforms and regulations are introduced by the federal bank through its monetary policy.

Monetary policy can be defined as an “Instruments of Control” that a federal bank, in agreement with its respective government policy, use to control (i) price stability, (ii) inflation, (iii) money supply, (iv) exchange rates, (v) unemployment and (vi) Sustainable output. Each of these components highlighted have drastic implications for the short term and long term economic growth rates.

Taking into consideration the main area of this study, we aim to understand how monetary policy can influences stock markets. To do this, we first need to know why capital moves from one sector/economy to another. How does current short term and long term interest rates influence the demand for money? Interest rates are used to control inflationary pressure and to control flow of money into the economy. Excess demand and supply for money in the economy can create inflationary pressures. These inflationary pressures and demand and supply of money are controlled through monetary policy.

1.1 Monetary Policy.

By applying macroeconomic principles we know that movement of capital takes place to profit from sudden and unexpected changes in market sentiments. Consider a situation wherein there has been a sudden drop in interest rates by the federal bank. A drop in interest rates has positive implications in the sense that borrowers would find it cheaper to raise capital from the market. But why would a private lender lend his capital in an economy when he can profit by lending his capital for higher returns in some other economy ? This may force the lender to take his capital out of the economy to some other profitable destination. Such movement of capital – in and out of the economy will put pressure on the exchange rate to change.

By how much does this movement will affect the exchange rate would depend by how much the federal banks lending rates can offset the negative implications of capital transfer by the capital lender. Whether positive or negative, the federal bank would have to devise a strategy to meet the demand for money not only by domestic borrowers and lenders but also by foreign borrowers and lenders.

Expansionary and restrictive monetary policy can both have inflationary pressures. Curbing money supply with higher interest rates would lead many borrowers of capital to transfer these additional costs on to their customers. On the other hand, expansionary monetary policy with lower interest rates would lead to excess spending as disposable income increases. This would cause the prices to increase beyond the sustainable level. In this case, the primary objective of monetary policy is to maintain prices at a sustainable level.

Such economic trends would warrant a monetary policy that can pump and pull money out of circulation, keep the real interest rates level at an optimum level and ensure that the domestic currency’s external value is determined by the market forces of demand and supply..

1.2 Stock Markets.

Business establishment look at various sources to raise capital to meet its expenditure requirements. They do so by raising capital from the market by selling equity to shareholders. Shareholders invest in anticipation of higher dividends. Firms need to raise capital from the market to meet its short and long term obligations. Suppose that a firm is not able to raise capital at an affordable rate, it would be forced to transfer the additional costs of borrowing on to its customers. Such an action would make its output more expensive in the market and it can have consequences for its profits generation and dividend policies. Less profits and lower dividends can hamper shareholder interests and its equity prices may take a drop.

How does monetary policy work towards bringing stability in the stock market prices ? Stock prices are among the most closely watched asset prices in the economy and are viewed as being highly sensitive to economic conditions. Stock prices have also been known to swing rather widely, leading to concerns about possible “bubbles” or other deviations of stock prices from fundamental values that may have adverse implications for the economy.

Taking into considering what stated above, we shall therefore look at the ways monetary policy, given its first objective of maintaining price stability in the economy, influence stock prices. The next chapter looks at some existing literature review on this topic.

1.3 Objectives and Methodology.

The objective of this study is to first looks at the basics of monetary policy as a macroeconomic stability instrument. There has been considerable debate over the implications of monetary policy over the stock markets. This has largely been due to the uncertainty associated with the stocks and its prices. These uncertainties seem to affect risk premiums added to stock prices more than stock market index and the stock dividends.

Chapter 2 looks at the literature review of existing articles and discussions on the importance of monetary policy for regulating stock markets. These chapter analyses the argument that monetary policies do not necessary have large scale implications for the stock markets. In chapter 3, I look at the need for regulation in the stock market and the factors that contribute in the making of the monetary policy. I have reproduced a chart representation of the US Federal Reserve and the factors that contribute in its monetary policy.

We shall also be looking at the trend pattern in the FTSE 100 stocks with the Bank of England interest rates since 1995/96. In the graphical representation to follow in the chapter 4, I have taken into consideration the statistical historical data pertaining to FTSE 100 stocks, inflation rate and the Bank of England interest rates.

I shall also be looking at the correlation that may exist between the interest rates and inflation rates in the UK. In order to have a better understanding of the relationship I have taken into consideration a 10 year period split into two parts – 1996/00 and Jan 04/Oct 05. I have also produced one multiple variable regression model to look for variance in the percentage change in the FTSE 100 index due to the variance in the inflation rate and interest rates.

While assessing any topic pertaining to financial markets, it is essential that we give due consideration to the uncertainty that governs this sector of the economy. As we have seen in the previous chapter, financial products, its demand and the variance in their values are highly sensitive to market sentiments. Some experts suggest that monetary policy have comparatively less impact on the stock markets index while some suggests it affects the risk premium associated with shares.

There are no pure economic explanation that explains whether or not monetary policy have any clear cut explanation for the changes in the stock markets and vice versa. But we do know that investors do look at government policies to formulate their strategies towards investments and monetary policy is one of the many such influencing factors.

Whatever the case, we know that government policies are essential for the smooth functioning of the market. Reilly et al (2003) states that “monetary and fiscal policy measures enacted by national governments, as well as changes in demographic, politics, and technology influence aggregate economies. The resulting economic conditions influence all industries and companies within the economies”.^[1]

Eichengreen and Tong (2003) argue that “having volatilities in the financial markets are not a bad thing in and of themselves.”^[2] Unexpected changes in the prices of assets acts as a signal to investors about the changes in future outcomes and their implications for the resource allocation. The extent to which the volatility of asset prices varies reflects the volatility in the policy and higher volatility may be an indication of a deteriorating policy environment. There appears to be a two way interaction between the market forces influencing the movement in the stock markets and the policy formation by the central banks.

An unanticipated change in monetary policy is likely to have implications for the stock markets because an anticipated change would logically be discounted by stock market investors and they are unlikely to affect equity prices at the time they are announced. Governor Ben Bernanke (2003) states that “unanticipated changes in monetary policy affect stock prices not so much by influencing expected dividends or the risk-free real interest rate, but rather by affecting the perceived risk associated with stocks”.^[3] We can understand from this statement that any unanticipated change in monetary policy is likely to increase the risk premium associated with the stock more than the expected dividends. Higher risks always come with higher premiums to compensate for bearing the uncertainty over the expected returns.

For example, a restrictive monetary policy will lead investors to view stocks as riskier investments and thus may demand higher returns to hold stock. In simple words, a restrictive money supply policy through higher interest rates would make stocks to be more risk borne for a given path of expected dividends as higher expected return can be achieved only by a fall in the current stock price. More so, tightening of monetary policy has a particularly strong impact on firms that are highly bank-dependent borrowers as banks reduce their overall supply of credit.

Government policies play an essential role in terms of investor confidence. Consider a situation wherein the government on recommendation by the federal or central banks decides to raise the investment FDI cap for foreign investors by certain margin. Investing firm will look at domestic markets for funding besides their own capital sources to invest. This investor confidence building measures are likely to attract investor to invest their capital by buying shares. But the extent to which such reforms are likely to succeed would depend on the rate at which such capital are available, policies towards repatriation of profits, exchange rate policies, reforms and regulations that allow firms to raise capital from the market.

If the investor expects the likely returns from stocks to be less, it would make more sense for him to look at other financial derivatives and products such as Bonds for investment. Unlike Shares, Bonds are far less risk prone as the returns and period of investment is well established. Bonds come with specific-guaranteed returns and the investment period is decided upon at the time of issuance and purchase.

Risks may come in the form of interest rates charged on raising necessary capital from the market. Talking of risks, if the investor is risk averse, there are possibly only two things that can deter stock markets from operating under market conditions. Firstly, the news that affects investors forecasts of current or future tax-deducted dividends and secondly, the forecasts on the current and future short term interest rates. From the company accounting point of view, what most investors are concerned about is the company’s ability to pay back short term credit loans and the interest rates charged over it. So if the federal banks raise short term interest rates, it might deter companies from meeting its short term obligations to the markets and investors from investing because current higher interest rates would make future dividends to be less valuable.

Similarly, if the short term interest rates for lending are higher than the tax-deducted dividends receivable from stocks, Investors would find it more reasonable to lend their capital elsewhere at a rate that at least equals the bank’s short term interest rates which is higher than the receivable dividends from the stocks.

In support of my argument, I shall highlight a particular remark made by Governor Ben Bernanke, US Federal Reserve (2003), “to value future dividends, an investor must discount them back to the present; as higher interest rates make a given future dividend less valuable in today’s dollars. Higher interest rates reduce the value of a share of stock”. Given these circumstances and as stated earlier, an investor would find other financial products such as Bonds more profitable to invest.

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Another important aspect of monetary policy influence over stock markets is its ability to manage “Bubbles” or “Boom” in the index. According to Bernanke, it is often difficult to identify in advance the factors that cause these bubbles. It is also pointed that the difficulty in pointing out comes from the fact that some bubbles may be of certain asset class which may, at times, influences the bubbles in other asset classes. Therefore any attempt to bring down stock prices by a significant amount using monetary policy is likely to have highly deleterious and unwanted side effects on the broader economy.

Moving on to risk in this sector, we know from our understanding of the financial markets that not all investors are risk averse. Some tend to profit by speculating market behaviour and trends forecast for the future. Sloman (1995) states that if the prices are currently rising, then people may speculate whether or not the prices will go up or down. Such speculations add to the risk factor which makes any financial securities expensive. Speculations tend to be self-fulfilling in the sense that every actions of those who speculate in the markets tend to come from sheer anticipation about market behaviour and the actions of those who influence such market behaviour.

Stocks, when compared to other financial assets, are considered to be more risk prone and therefore command higher than average returns. In the US, a diversified portfolio of stocks has paid 5 to 6 percent points more per year on an average than other portfolio comprising government bonds.^[4] Such speculations only add to the risk premiums on stocks which explain the extra compensation that investors demand to be willing to hold relatively more risky stocks.

One study conducted by Roberto Rigobon and Brian Sack shows that it is difficult to estimate the policy reaction because of the simultaneous response of equity prices to interest rate changes. The results obtained in their study shows that “monetary policy reacts variedly to stock market movements, with a 5 percent rise (fall) in the S&P 500 index increasing the likelihood of a 25 basis point tightening (easing) by about a half. This reaction is roughly of the magnitude that would be expected from estimates of the impact of stock market movements on aggregate demand. Thus, it appears that the Federal Reserve systematically responds to stock price movements only to the extent warranted by their impact on the macroeconomy”. They simplify the concept by showing that if the probability of a monetary easing were 30 percent under existing economic conditions, an unexpected 5 percent decline in stock prices would increase the probability of a cut in the Fed’s benchmark short-term interest rate to 80 percent. ^[5]

To support this argument put forward by Rigobon and Sack, I shall highlight the point put forward by Bernanke who points out that “an unexpected change in the federal funds rate of 25 basis points leads, on average, to a movement of stock prices in the opposite direction of between quarter percentage point and one / one-half percentage points”.

Participants in the stock markets monitor economic indicators such as employment, GDP, retail sales and personal income because these indicators may signal information about economic growth and therefore affect cash flows. In general unexpected favourable information about the economy tends to cause a favourable revision of a firms expected cash flows and therefore place upward pressure on the firm’s value. Therefore, an easing of monetary policy would provide for an increase in wealth as stock prices increase which would prompt higher consumer spending. From a corporate point of view, higher stock prices would effectively reduce the cost of capital for firms stimulating increased capital investment. On the other hand, an unanticipated monetary policy would lower stock prices but increase risk premium.

Easing monetary policy would provide for increased savings largely due to the decrease in risk associated with stocks. Results for Bernanke’s study suggest that “easier monetary policies not only allow consumers to enjoy a capital gain in their stock portfolios today, but it also reduces the effective amount of economic and financial risk they must face”. Thus, a reduction in risk associated with an easing of monetary policy and the resulting reduction in savings for precautionary purposes may amplify the short-run impact of policy on the asset value ^[6]

Issues such as Inflation act as an indicator for economic growth. Rising inflation in most cases are dealt by accommodating interest rates to control the flow of money. For instance, often inflation is caused by the presence of excess money in the economy. The government might decide that the best way to tackle this problem is by increasing the interest rates. Raising interest rates would cut excess expenditure, reduce excess consumer demand thereby bring an equilibrium between aggregate demand and supply. Raising prices can also be tackled by raising interest rate by curbing unwanted expenditure.

Bernanke and Gertler (1999) argue that monetary policy that aims at flexible inflation must pay little attention to asset inflation because a proper setting of interest rates should be able to achieve a sustainable inflation rate.^[7]Analysing this argument, and looking at the evidence put forward by Bernanke (2003), changes in the monetary policy do not bring about immediate changes in the stock markets behaviour but maintains inflation rate at sustainable level.

In this section, we looked at arguments put forward by Bernanke (2003), Reilly et al, Bernanke and Gertler (1999) to understand the existing study on the likely impact of monetary policy on stock markets. Despite all these suggestions, there appears to be little agreement over the exact and precise impact of monetary policy in the stock market.

In the next chapter I shall look at the basics of financial markets and look at the regulation policies followed by the US Federal Reserve. I have also reproduced a chart representation of factors that influence the US stock prices.

Financial Markets play a prominent role in today’s economy. Though in the past during industrial-manufacturing era of the 1800s/1900s, it can be argued that role of finance was narrowed down to basic accounting purposes such as the cost of production. Today, with the advent of various financial products and the integration of world economy financial sector it requires constant regulatory procedures for its smooth functioning. The financial crisis witnessed in East Asian economies, Mexico, and Argentina has made financial regulation and reforms an essential component of any government’s economic policy.

In their regulatory capacities, governments have greatly influenced the development and evolution of financial markets and institutions. Fabozzi et al (2002) points out that “it is not surprising to find that a market’s reaction to regulations often prompt a new response by the government, which can cause the institutions participating in a market to change their behaviour further and so on”.^[8] It can be understood by this argument that at all times governments, markets, and institutions tend to behave interactively and to affect one another’s action in certain ways

3.1 Need for Government Regulations

One very good and justifiable explanation for the need for regulation in any markets, not just in financial markets, is that when markets are left to it self, it tends to deviate from its basic objective of market efficiency. A short hand expression for this deviation from market efficiency is described in economic terminology as “market failure”. Some basic regulations followed by many governments can be categorized into 4 basic categories –

To prevent issuers of securities such as stocks, bonds, from concealing relevant information.
To promote competition and fairness in the trading of financial securities.
To promote the stability of financial institutions.
To control and restrict activities of foreign institutions and concerns in domestic markets.

3.1.1 Regulations in the UK.

One of the major regulatory procedures ever adopted by the British government was during the mid-1980s when it introduced the “Big Bang” disclosure of information by the securities markets. An Important part of that restructuring was the Financial Services Act of 1986. This law imposes a “general duty of disclosure” and applies to any foreign or domestic firm that issues debt or equity securities, whether or not the securities are to be listed on the London Stock Exchange.

The Financial Services Act assigns responsibility for regulating financial activity to the Department of Trade and Industry (DTI). The DTI delegates much of the task to the Securities and Investment Board (SIB). The SIB is the primary agency that authorizes institutions to conduct investment business and monitors their dealings with the public and the adequacy of their funding.^[9]

The Bank of England now regulates most banking institutions in much the same way as the US Federal Reserve. Until the Big Bang of 1986, banks were not permitted to engage in many activities involving the sale of securities. Since then banks are not allowed to own subsidiaries that are members of the stock exchange, which offers investors many financial services linked to investing. Non-British firms are now allowed to be part of and even lead the groups of underwriting firms that sell to the public new issues of debt and equity denominated in pound sterling.

3.1.2 Monetary Policy and Regulations in the US.

One of the major duties of US Federal Reserve is serving on the Federal Open Market Committee, the body that makes US Monetary Policy.^[10] As we have seen earlier in the first chapter, the primary objective of monetary policy is to maintain the macroeconomic stability in terms of price levels, unemployment, exchange rates, and interest rates. Federal Banks, often, use interest rates as a means to control inflation. To what extent can the bank control interest rates is a matter of debate especially since most economies work on market economy principles.

United States have brought extensive reviews and changes to its policies regarding domestic and foreign firm’s participation in the financial markets. In 1984, the federal government abolished the withholding tax on interest payments to non-resident holders of bonds issues by US firms. In 1987, US markets obtained permission to trade futures based on foreign government bonds

This illustration shows the reasons and factors that influence the stock prices to change in the US.^[11]

According to Governor Bernanke the US Federal Reserve have little or no direct control or influence over the interest rates that matter most for the economy, such as mortgage rates, corporate bond rates or the rates on Treasury securities. In support of his argument, I shall point out similar policy constraints faced by the German government since joining the EMU. Fabozzi et al (2002) points out that “the European Central Bank replaced the central bank of 11 participating countries of the European Economic and Monetary Union (EMU). ECB, since then, controls the money supply, availability of credit and short term interest rates for the EMU members and has also influenced the uniform currency of the EMU”.

Given these regulatory frameworks how far are the bank’s monetary policies a determining factor in the stock exchange. The idea of this chapter was not to explain each and every regulatory technique the banks use but to have slim-shot view of the factors that influence bank’s monetary policy. The chart representation quite clearly shows the factors that contribute in the US Federal Reserve monetary policy.

In the next chapter we shall look at some historical trends and then use those trends to arrive at some econometric models.

Considering the fact that central banks are increasing looking at market forces to control interest rates, the role of financial regulatory bodies becomes complex. Broadly speaking, to have efficiency in the financial markets, it is essential that the bank is able to determine the degree of financial stimulus needed to push the economy to its optimal level.

Monetary policy, in this situation, should strive to provide this stimulus. For example, lower mortgage rates promote increased spending on new homes and lower corporate bond yields and high stock prices generally induce firms to invest in new capital goods. Similar to these rates stated now, lower interest rates should act as an incentive for firms to borrow and invest in lucrative products. From the long term perspective, obtaining credits are comparatively less complicated. Short term credits are more essential as firms often have to meet its short obligations by borrowing.

Firm’s ability to meet its short and long term obligations act as an indicator for shareholder to assess whether are not they should invest their capital. These short and long term obligations are determined by the interest rates. Failure of the markets to provide funds at affordable rates has consequences for economic growth. A r