Quantitative Easing and US Stock Prices

Abstract

Conventional wisdom is that unconventional monetary policy a.k.a. Quantitative Easing (QE) pursued by the Federal Reserve has helped sustain and even boost U.S. stock market prices in the aftermath of the Global Financial Crisis. By design, QE has supported long-term Treasury bond prices and put downward pressure on long term rates; however the link to stock prices is more complicated because other factors operate as well, e.g., the performance of stock markets in the rest of the world, US dollar performance, virtually zero fed funds rate via conventional monetary policy (independent of policies such as QE), and changes in the interaction between economic activity and credit conditions – as measured for instance by the high yield spread along the lines of the financial accelerator theory. This paper presents evidence that these other factors explain most of the variation in stock returns before and after the financial crisis with stable coefficients and that the different rounds of QE explain significantly some of the remaining variation in stock prices. A vector autoregression provides further evidence of the effects of QE on stock returns and its relative importance vis-a-vis other variables via a Pesaran-Shin generalized impulse-response analysis (invariant to the causality ordering). The evidence in this paper is consistent with the boost in stock prices after the Fed actually started tapering in January 2014 because the “fundamentals” were supportive of the stock market. Furthermore, if the positive effects of QE on the stock market are less strong than commonly believed, the negative effects from a gradual shrinking of the Fed’s balance sheet may not be as bad as commonly feared.