The impact of monetary policy shocks on the equity risk premium before and after the Quantitative Easing in the United Kingdom

Sunil Poshakwale,Pankaj Chandorkar

doi:10.21511/imfi.13(4-1).2016.01

Sunil Poshakwale, Pankaj Chandorkar

Open Access

https://doi.org/10.21511/imfi.13(4-1).2016.01

Copy DOI

Abstract

The authors investigate the impact of structural monetary policy shocks on ex-post equity risk premium (ERP) of aggregate and sectoral FTSE indices and 25 Fama-French style value-weighted portfolios. They find that monetary policy shocks negatively affect the ERP but at the sectoral level, the magnitude of the response is heterogeneous. Further, monetary policy shocks have a significant negative (positive) impact on the ERP before (after) the implementation of quantitative easing (QE). The empirical evidence provided in the paper sheds light on the equity market’s asymmetric response to the BoE’s policy before and after the monetary stimulus. Keywords: monetary policy, equity risk premium, quantitative easing, monetary policy shocks, structural vector autoregression, Bank of England, Taylor monetary policy rule, unconventional monetary policy, output gap, inflation gap, Okun’s law. JEL Classification: E5, E30, G0, G1

Highlights

The UK’s monetary policy has twin objectives of price and financial stability
This paper investigates the impact of monetary policy shocks on the equity risk premium (ERP) in the UK before and after the quantitative easing (QE) which was introduced in the wake of 2007-2008 financial crisis
Our results show that a positive monetary policy shock, i.e. when the actual interest rates are more than the expected interest rates has a negative impact on the ERP of most of the FTSE Indices

Summary

Introduction

The UK’s monetary policy has twin objectives of price and financial stability. the Monetary Policy Committee (MPC) of Bank of England (BoE) has to maintain 2% target inflation as required by the Treasury, whilst the Financial Policy Committee (FPC) monitors the systemic risks to the financial markets. Out of the seven possible channels that they postulate, the signalling channel seems to be more promising Under this channel, the inclination of a central bank to keep the interest rate lower than that implied by the Taylor (1993) rule leads to lower yields on long-term bonds and higher prices of risky assets. The first is the portfolio substitution channel which is known as portfolio re-balancing channel 1 Under this channel, the BoE buys gilts from the non-bank private sector investors, such as pension funds and insurance companies by financing the purchase using central bank reserves. The BoE buys gilts from the non-bank private sector investors, such as pension funds and insurance companies by financing the purchase using central bank reserves These deposits are likely to be imperfect substitutes of the assets that are sold by the private sector to the BoE. Declining yields on long term bonds encourage the private sector to raise new debt for financing new investments and/or dividend payments to equity holders

Methods

Results

Conclusion