Evolution of Monetary Policy in the U.S.: The Role of Asset Prices

Abstract

This paper investigates whether changes in the monetary transmission mechanism as captured by the interest rate respond to variations in asset returns. We distinguish between low-volatility (bull) and high-volatility (bear) markets and employ a TVP-VAR approach with stochastic volatility to assess the evolution of the interest rate in relation to housing and stock returns. We measure the relative importance of housing and stock returns in the movements of the interest rate and their possible feedback effects over both time and horizon and across regimes. Empirical results from annual data on the US spanning the period from 1890 to 2012 indicate that the interest rate responds more strongly to asset returns during low-volatility (bull) regimes. While the bigger interest-rate effect of stock-return shocks occurs prior to the 1970s, the interest rate appears to respond more strongly to housing-return than stock return shocks after the 1970s. Similarly, a higher interest rate exerts a larger effect on both asset categories during low-volatility (bull) markets. Particularly, larger negative responses of housing return to interest-rate shocks occur after the 1980s, corresponding to the low-volatility (bull) regime in the housing market. Conversely, the stock-return effect of interest-rate shocks dominates before the 1980s, where stock-market booms achieved more importance.