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How Monetary Policy Can Influence Stock Market

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  • Rakesh Kumar Nair

Table of Contents (Jump to)

1.0 Introduction - Understanding Monetary Policy and Stock Market.

1.1 Monetary Policy.

1.2 Stock Markets.

1.3 Objectives and Methodology.

2.0 Literature Review.

3.0 Financial Markets Explained.

3.1 Need for Government Regulations

3.1.1 Regulations in the UK.

3.1.2 Monetary Policy and Regulations in the US.

4.0 Analysis of Interest Rates, Inflation and Stock Market.

4.1 Post – 1995 Trends in Inflation, Interest Rates and Stock Market.

4.1.1 Correlation between Inflation Rates and Interest Rates.

4.1.2. Influence of Inflation Rates and Interest Rates on FTSE 100 Index.

5.0 Conclusion.

References.

Tables

Table One: Chapter 4, Chart I and II, FTSE Stock Index 1995/2005, and Bank of England Interest Rates.

Table Two: Chapter 4, Chart III and IV, Comparison UK Interest Rates, Inflation Rate, and FTSE Stock Index (percentage change).

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.

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.

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 -

  1. To prevent issuers of securities such as stocks, bonds, from concealing relevant information.
  2. To promote competition and fairness in the trading of financial securities.
  3. To promote the stability of financial institutions.
  4. 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 restrictive monetary policy with high interest rates reduces growth rate of the money supply which in turn reduces the supply of funds for working capital and expansion for all business.[12]

An economic analysis of monetary policy should consider inflation. Inflation changes the spending and savings behaviour of the consumer and corporation. The differential inflation and interest rates influence the trade balance between the countries and exchange value of their respective currencies. These differentials would consequently be a determining factor in the movement of capital between these trading countries. Inflationary pressure would severely impact consumer’s spending capabilities which hamper company profits and force many to change their dividend policies. Such market inefficiency would impact the stock markets as investor would find it unprofitable. Consider this example obtained by Reilly and Norton (2003) assessing the performance of US stocks in different economic scenario.[13]

Table I: Price - Earning Ratios under Various Inflation Conditions

Inflation Rate

Average S and P 500 P-E Ratio

Less than 3.5 %

16.2

Less than 4.5 %

15.3

4.5 % to 5.5 %

15.6

5.5 % to 6.5 %

12.1

6.5 % to 7.5 %

10

Greater than 7.5 %

8.6

This table shows that stocks have higher price-earning ratio at lower inflation rate and the ratio tends to fall as the inflation increases. It is suggested that one reason for the higher price-earning ratio is the expectation of higher earnings growth.

Although Inflation is a mainly a monetary phenomenon, at times market inefficiencies such as raw material shortages can cause increases, albeit temporary, in the inflation rate. Inflation usually occurs when short term demand outstrips the long term supply constraints. Inflation adds a layer of uncertainty to future business and investment decisions, which increases risk premium.[14]

4.1 Post – 1995 Trends in Inflation, Interest Rates and Stock Market.

In this chapter, we shall first look at the trends witnessed in the FTSE 100 stocks and the Bank of England Interest Rate since the beginning of the year 1995. The idea here is to compare the trend pattern between the FTSE 100 Index and the Bank’s interest rates for same period. In chart I, we can observe that starting January 1995 until mid-1998 FTSE 100 index showed steady growth rate followed by some large upward and downward movement in the index towards the beginning of 2000. This wide scale movement during the late 1990’s and early 2000 could be attributed to the boom and crash of the IT sector and also the Middle Eastern crisis. The Index witness some serious downfall in the stock value until it picked up since the beginning of 2003.

Chart I – FTSE 100 Index[15]

Chart II – Bank of England Interest Rates[16]

Analysing the graphical representation of the Bank’s interest rates, we can observe that since the beginning of the year 2003, the Bank of England cut interest rates from 4 percent to 3.75 percent which continued within the 3 percent mark till the beginning of the year 2004. During this period the index showed steady and positive growth pattern. Could this cut in the interest rate be attributed for surge in the index which otherwise saw tremendous drop prior to its cut ? As per macroeconomic principles, cut in the interest rates should create a positive investment climate as capital could now be borrowed from the market at a cheaper rate. It is very well possible that this drop in the bank rate may have attributed for the sudden and steady surge in the index value.

In contrast, if we look at the index and bank interest rate figures (Jan 2001/Jan 2003) we can observe that despite the bank cutting interest rates from 6 percent to 4 percent (over and above) level the index still showed negative growth pattern. This cut in interest rate should ideally have brought the FTSE index up. However, we can observe a massive decline in market optimism and investor confidence during this period. It could be possible that there could have been some other factors that may have influenced this negative growth pattern in the index despite the cut in interest rates. It may also be noted that almost throughout 2004 the bank rate had been steady at 4.75% which may have had some implications on the investor interest towards the market and government macroeconomic policies.

This scenario makes it essential for us to look at the inflation rate during this period. As we have noted earlier, raising inflation rate tend to have consequences for the stock markets as an uncontrolled surge in price could drive consumers away from the market driving the overall sales figures down in the market.

Chart III – UK Inflation Rate – Retail Price Index.[17]

Assessing the period during which the FTSE 100 showed negative trend pattern (Jan 01 / Jan 03) the inflation rate showed significant decline and rise. This period witnessed large scale surge and drop in the retail price index while the FTSE index too witnessed lower investor confidence. Post-January 2003 till October 2005, we can observe that the interest rate have risen by a small fraction, the index too have showed positive trend pattern while the inflation rate have risen and then dropped slightly. The current inflation rate as of October 2005 is estimated to be at 4.5%. In Chart IV, we can see that both rates show a trend pattern that is similar and identical.

Chart IV – Graphical representation of changes in percentage a changes in FTSE 100 Index compared to Interest Rates and Inflation Rates.

4.1.1 Correlation between Inflation Rates and Interest Rates.

In this section, I shall try to produce four simple two variable regression models. Through these simple regression models I shall look at the relationship that exists between the two variables in their respective variability. The period I shall be considering starts from January 1996 till October 2005. In Model I (a), I have taken a 60 month observation starting January 1996 till December 2000 and in Model II (a) and (b) the observation period starts January 2004 and ends in October 2005. In Model I (a), I shall consider Interest Rates as the dependent variable and the Inflation Rate as the independent variable. The idea is to establish whether or not a percentage change in the interest rate has any affect on the inflation rate [in Model I (b) vice versa]. [18]

Regression models are of type Yi = αi + β Xi + µi

Model I (a)

Duration: Jan 96 / Dec 00.

Observations: 60.

Chart: V

Independent Variable (Xi): UK Inflation Rates (RPI).

Dependent Variable (Yi): UK Interest Rates.

Yi = 4.084 - 0.788 (Xi) + µi

(0.183) (0.066)

R2 = 0.845

Chart V

In this simple 2 variable regression model, I aim to establish whether or not any direct correlation exist between these variables. As I have stated earlier, the idea here is to see whether interest rates have any likely influence on maintaining inflation rate at a sustainable level.[19] We can see that during 1996 and 2000, every 1 percent increase in the inflation rate triggered the interest rate to go up by 0.78 percent. The R2 value of 84.5 percent explains the important relationship that exists between these two variables. Federal bank often use interest rates to curb inflationary and deflationary pressures in the economy. The chart above shows the distribution of error terms around the regression line or rather the “goodness of fits”. We can see that the errors terms are clustered around the regression line. The low standard errors (0.183) and (0.066) shows that there is very less possibilities for the beta values to take some other value (4.084 and 0.788). As per econometric principles the lower the standard errors, better the possibility that we have obtained a beta value consistent or equal to the actual/expected beta value.[20]

Since monetary policies are short term measures aimed at correcting inefficiencies in the economy it is essential that we look at the short term implications of the changes in the inflation rate on the current interest rates and vice versa. It is for these reasons in model two I have considered a shorter time period consisting of lesser observations.

Model I (b)

Duration: Jan 04 / Oct 05.

Observations: 22.

Chart: VI

Independent Variable (X φ): UK Inflation Rates (RPI).

Dependent Variable (Y φ): UK Interest Rates

Y φ = 1.999 + 0.843 (X φ) + µφ

(0.517) (0.174)

R2 = 0.735

In model I (b), we can observe that for every 1 percent rise in inflation, the interest rates also rise exceptionally by 0.84 percent. These figures explain why interest rates are often used as a primary mechanism to correct market inefficiencies such as sudden rise in prices. R2 value of 73.5 percent explains that explanatory power of the inflation rate on the variability in the UK interest rates. Comparing the two time period we can see that though R2 value is lower in the shorter period, it still remains fairly high suggesting that the two variables essentially have an important determining factor between them

We can observe by comparing the beta value in the short term period that the explanatory power of the inflation rate for the variance in the interest rate is lower and more significant though the numerical difference between the two beta values is not much. What it implies is that both inflation rate and interest rate are determined in such a way that both compliment the variance in time between them.

The federal banks often rely on interest rates to correct the rise and fall in prices (inflation). This is done primarily because if there is a sudden rise in commodity prices, the bank use interest rates as a means to prevent unnecessary expenditure. For example, if for some specific reasons the money supply increases inducing a sudden surge in expenditure due to large disposable income in the economy, the prices are expected to rise as response to increase in demand. These market anomalies can be corrected by pulling this excess money out of circulation.

Chart VI

Model II (a)

Duration: Jan 96 / Dec 00.

Observations: 60.

Chart: VII

Independent Variable (X ii): UK Interest Rates.

Dependent Variable (Y ii): UK Inflation Rates (RPI).

Y ii = - 2.927 + 0.906 (X ii) + µii

(0.471) (0.075)

R2 = 0.845

Chart VII

In model II, the objective is to see what happens when we consider inflation rate as the dependant variable. The idea behind this is to see whether inflation reacts to a change in interest rates. We can recall from previous chapters that movement in interest rates have implication for the current level of inflations. Madura (2003) states that higher interest rates level increase the corporate cost of financing new projects which causes a decrease in the level of business investment. As economic growth is slowed by the reduction in business investment, inflationary pressures may be reduced. Thus reducing money supply is an indirect means by which the federal banks reduce inflation.[21]

In model II (a), 1 percent increase in the interest rates brings about 0.90 percent rise in the inflation rate. Such high correlation between the variables is largely because of the risk associated with raising necessary capital from the market to meet short term expenditure and credit obligations. We may recollect that rising interest rates would make investors to look at other profitable and secure financial securities such as bonds. Investors would be driven away by the lower returns he/she is likely to gain from investing in expensive.

Model II (b)

Duration: Jan 04 / Oct 05.

Observations: 22

Chart: VIII

Independent Variable (X ψ): UK Interest Rates.

Dependent Variable (Y ψ): UK Inflation Rates (RPI).

Y ψ = 0.080 + 0.641 (X ψ) + µ ψ

(0.596) (0.132)

R2 = 0.735

We can observe in this regression model that there appears to be a significantly high correlation between the two variables. The R2 value or rather the Coefficient of Determination explains that 73.5 percent of the variability in the inflation rate is explained by the variation in the interest rates. More precisely, for every 1 percent increase in the interest rates, the inflation rates increases by 0.64 percent which is significantly high.

Chart VIII

Such high explanatory power of interest rates explains that an increase in interest rates has driven prices up in the economy. The standard error for the explanatory variable is significantly low. We know from our understanding of monetary economics that an attempt to raise interest rates will reflect on the inflation rate as borrowings are made expensive and firms would transfer this additional “burden” on to the customers.

In both the periods we have seen that the explanatory power of UK interest rates have remained high.

Model III

Duration: Nov 03 / Oct 05.

Observations: 24

Chart: IX

Independent Variable (X ψ): UK Interest Rates.

Dependent Variable (Y ψ): FTSE 100 Index (percentage change).

Y ψ = - 1.858 + 0.460 (X ψ) + µ ψ

(3.093) (0.696)

R2 = 0.14

The results obtained by regressing the interest rates against the percentage changes in the stock index appear to support the views expressed by the Mr. Bernanke. Governor Bernanake had stated, as we can recall, that in general stock prices tend to be less responsive to fluctuations in the interest rates as most anticipated changes tends to be discount by the investors. It will only add or push the risk premiums up and increase the over all stock prices.

Chart IX

If we analyse the results, we can see that a 1 percent increase in the interest rate brought only 0.46 percent increase in the stock index. It is possible that during this period the investor were very well aware of the policies of central bank. We can also notice, if we look at the interest rate table for this period, it has remained fairly constant. Since September 2004 till August 2005, interest rates have remained constant at 4.75 percent. However, as interest rates tend to push prices up the share prices also goes up as investors anticipates higher returns for their investments. This could be one reason why an increase of just 1 percent pushed the percentage change in the index by almost half a percent.

The explanatory power of the interest rates for the changes in the stock index is significantly low at just 14 percent thereby suggesting that changes in FTSE stock index could have been due to variety of other relevant reasons. Reasons such as oil prices crisis, Iraqi war may all have contributed in its variability.

4.1.2. Influence of Inflation Rates and Interest Rates on FTSE 100 Index.

We have so far considered 4 cases of inflation rate and interest rate interacting with each other and the extent to which they are both a determining factor in their respective variability. We have looked at an interesting regression model showing the relationship between Interest rates and the percentage change in the FTSE 100 Index. In this section, I shall look at both Interest Rates and Inflation Rates as the determining factor in the movement of the stock index. I shall see to what extent both these variables influence the changes in the stock index.

Multiple Regression Model of type - Y1 = α1 + β1X1 + β2X2 + µ1

Duration: Jan 01 / Oct 05.

Observations: 58.

Independent Variable (XB): UK Inflation Rates (RPI).

(XC): UK Interest Rates.

Dependent Variable (YA): FTSE 100 Stock Index (% change).

YA = - 1.301 + 1.020 (XB) - 0.452 (XC) + µ2

(3.442) (0.630) (0.689)

 

R2 = 0.23

In this multiple variable regression model we try to ascertain the extent to which both these variables explain the changes in the FTSE Index. It must, however, be noted that while we consider both the variables (XB and XC) in this model, we measure the variance in stock index due to interest rates by isolating all influences of inflation rate. Similarly, while measuring the influence of inflation rate we isolate all influences by the interest rates.

The result obtained suggests that there appears to be an inverse relationship between the percentage change in the stock index and interest rates. For instance, 1 percent increment in the interest rates have resulted in a 0.45 percent drop in the stock index. This result obviously suggests the impact any positive change in the interest rate is likely to have on investor confidence and the impact it has on the stock markets. If we look at the R2 value, it is very low at just 23 percent. As I stated earlier, it may be due to factors such as foreign demand, unemployment, exchange rate differentials, and other financial securities all of which contribute in the daily movement of stock index.

There is a positive relationship between the percentage change in stock market index and inflation rate. They are positively related in the sense that one percent increase in the inflation rate results in 1.02 percent increase in the stock index. Though rise in inflation depicts increment in cost, it does not necessarily mean that the economy is slowing down. Federal bank, using it monetary policy, always aims at maintaining inflation rate within the acceptable 2.5 percent mark in order induce further investment. To achieve this objective it will use it interest rate policies to raise and drop inflation rate within the sustainable limits.

In this chapter, we produced and made use of econometric models to explain the relationship between interest rates, inflation and stock markets. We produced results that to large extent have been in sync with the views expressed by various individuals as we have discussed earlier in the literature review.

As we have seen through out this study that the relationship that exists between the monetary policy and stock markets remains different and somewhat inexplicable. We have looked at the argument puts forward by various personalities in particular Governor Bernanke of the US Federal Reserve who was of the view that monetary policy tend to affect risks premiums more than any other stock related prices or dividends.

By making use of some simple regression models, I have avoided introducing complex variable to arrive at some very straightforward relationship between inflation rate, interest rates and stock index. The aim of monetary policy, as we have seen earlier, is to accommodate macroeconomic stability in the economy. This stability comes from sustainable prices as determined by market forces, optimal interest rates that guarantee investor confidence, unemployment level that has consequences for the production conditions in the economy and the free market determined foreign exchange policies that facilitate free movement of capital to profit from interest rate differentials and competitive prices.

It is essential that inflation rate are kept in control to avoid excess inflow of goods from abroad which can work against the any country’s domestic production. The sudden drop in demand for domestic product will have consequences not only on the country’s foreign reserves but also on the investor’s decision to make available their funds for domestic investments.

In the regression models we have observed that inflation rate and interest rates remain highly correlated whether or not the period we took into consideration was large or small. The results obtained agree with the basic econometric literature that compliments the relationship between both these economic growth indicators.

Of all the regression models developed, the multiple regression model produce some interesting results that seems to “cancel” out the contribution of inflation and interest in ensuring macroeconomic stability. Recalling what Bernanke highlighted “since anticipated monetary policy will be discounted by the market, unanticipated monetary policy tend to have more influence on the stock risk premiums. The results obtained appear to be in agreement with his argument particularly since variance in inflation and interest rates had lower impact on the variance in the stock market index. We can very well assume and know by our understanding of the stock markets that whole gamut of economic issues affecting stock markets and investors around the world can change the sentiments in the domestic stock market overnight in any country.

Interest rates should be kept at all level that attract investors. As Bernanke and Gertler states that by reducing economic and spending activity through higher interest rates the risk of unemployment and bankruptcy faced by individual households and firms only worsens. By increasing interest rates and consequently cutting the money supply, the perceived risk premiums increases either by increasing the perceived risk associated with stocks and also by reducing people’s willingness to bear risks. Reduced willingness of investors to hold relatively more risky stocks drives down stock prices.

Lower interest rates can be achieved and market inefficiencies such as unemployment can be avoided only through proper regulations and reforms that agree with the current trends in the sentiments of investors and market behaviour in the future. The question to follow a restrictive or expansionary monetary policy would depend on these current trends. Historical date can provide us with some valuable information to learn from past market behaviour.

Therefore proper regulations and reforms should not only look at domestic macroeconomic scenario but also at the international markets as financial sector is no longer confined to accounting books but to a whole spectrum of financial products and agencies.

Jeff Madura, Financial Markets and Institutions, Sixth Edition, Chapter 5, Monetary Theory and Policy.

Damodar Gujarati, Basic Econometrics, McGraw- Hill Higher Education, March 2002.

Frank K. Reilly and Edgar A. Norton, Investments, Sixth Edition, Chapter 13, Economic and Industry Analysis

Bernanke and Gertler, “Monetary Policy and Asset Prices Volatility”, Federal Reserve Bank of Kansas City Economic Review, 84(4), 1999

Bernanke and Gertler, (1995) “Inside the Black Box: The Credit Channel of Monetary Policy Transmission”, Journal of Economic Perspective.

Frank J. Fabozzi, Franco Modigliani, Frank J. Jones, Michael G. Ferri, Foundations of Financial Markets and Institutions, 3 Edition, Chapter 3, Role of Government in Financial Markets.

Cecchetti, S. G., Genberg H., et al “Asset Prices and Central Bank Policy”, Geneva Report on the World Economy, 2, International Centre for Monetary and Banking Studies and Centre for Economic Research (2000).

John Sloman, Economics, Second Edition, (1995).

Internet Source:

http://www.incomesdata.co.uk/statistics/statrpi.htm

http://uk.finance.yahoo.com/q/hp?s=%5EFTSE&b=1&a=00&c=1995&e=31&d=09&f=2005&g=m

http://213.225.136.206/mfsd/iadb/Repo.asp?Travel=NIxIRx

http://www.federalreserve.gov/boarddocs/speeches/2005/20050330/default.htm

Table One: Chapter 4, Chart I and II, FTSE Stock Index 1995/2005, and Bank of England Interest Rates.

Year

Interest Rates

FTSE 100 Stock Index

03/01/1995

6.13

2991.6

01/02/1995

6.13

3009.3

01/03/1995

6.63

3137.9

03/04/1995

6.63

3216.7

01/06/1995

6.63

3314.6

03/07/1995

6.63

3463.3

01/08/1995

6.63

3477.8

01/09/1995

6.63

3508.2

02/10/1995

6.63

3529.1

01/11/1995


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