Monetary Policy and Predictability of Stock Returns: Evidence from a Liberalizing Economy

Abstract

In view of the shifting importance from banks to stock markets in India's financial sector, a growing view is that monetary policy should take into account its impact on stock markets alongside its traditional focus on the banking sector. With regard to this issue, we test for non-neutrality of monetary policy in affecting stock returns. Using the Vector Auto Regression (VAR) methodology, we find that growth in reserve money (as an indicator of monetary policy) granger-causes stock returns without any feedback effect. This is supported both by the traditional orthogonalized as well as the recently developed generalized forecast error variance decompositions where monetary policy accounts for most of the forecast error variance of stock returns. Our results also point towards the fact that the stock market in India is not efficient with respect to monetary policy in the semi-strong sense of Efficient Market Hypothesis.