Monetary policy effects on equity returns: application of SVAR identified with high-frequency external instrument

Woon Wook Jang

doi:10.1108/jdqs-08-2021-0021

Abstract

The purpose of this study is to examine the effects of monetary policy on equity returns by applying an alternative econometric approach. Campbell and Ammer (1993) decomposed unexpected equity excess returns into three news components: risk premium news, real interest rate news and cash-flow news. The literature has determined the monetary policy (MP) effects on these news components. The authors propose an alternative MP shock identification approach to analyze the MP effects on the above-mentioned news components under a structural vector autoregression (SVAR) setup. Under this approach, one can apply an MP indicator in the SVAR, which helps forecast equity excess returns along with its external instruments for identification. Further, this study uses the various recently proposed measures of exogenous MP shocks and Fed information shocks as external instruments, and shows the different patterns of the news components' responses depending on the information in the applied instruments.

Highlights

An unexpected drop in equity excess returns may be attributed to a decline in expected future dividends, an increase in future real interest rates or an increase in future risk premium
To analyze the components that derive an unexpected change in the equity excess returns, Campbell and Ammer (1993) used a log-linear approximation and decomposed unexpected equity excess returns into the three news components; they estimated the components using a vector autoregression (VAR) setup [1]
This study provides an alternative approach to analyzing the responses of unexpected equity excess return news components to monetary policy (MP) shocks in an structural VAR (SVAR) setup

Summary

Introduction

An unexpected drop in equity excess returns may be attributed to a decline in expected future dividends, an increase in future real interest rates or an increase in future risk premium. To analyze the components that derive an unexpected change in the equity excess returns, Campbell and Ammer (1993) used a log-linear approximation and decomposed unexpected equity excess returns into the three news components (i.e. risk premium news, real interest rate news and cash-flow news components); they estimated the components using a vector autoregression (VAR) setup [1]. Patelis (1997) used a structural VAR (SVAR) setup, wherein the endogenous state variables include MP indicator variables [2], and applied the Choleski decomposition (i.e. zero short-run restriction) to identify MP shocks. Bernanke and Kuttner (2005) assumed no MP indicators in the (endogenous) state variables in their reduced-form VAR model [3], but added an MP surprise measure as an exogenous variable.

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