buyingEvaluating Fiscal and Monetary Policy Impact on the London Stock Market
It is commonly accepted that the monetary policy impact on the stock market should not be examined separately from the fiscal policy one. Indeed, through their interplay, the government has a substantial impact on macroeconomic variables, such as interest rates, inflation or output, and hence affects the stock exchange. While changes in the economy occur within a certain period, stock markets tend to incorporate new policy peculiarities faster. Although a substantial number of previous studies focused their attention on the impact of monetary policy on the stock market, either in the UK or the international one, (Lildholdt & Wetherilt 2004; Bredin, Caroline & Gerard 2005; Gregoriou et al. 2009; Chatziantoniou, Duffy & Filis 2013; Razin 1991; Ioannidis & Kontonikas 2006; Wang & Mayes 2012; Bordo, Dueker & Wheelock 2007), few of them dedicated their attention to stock market responses to fiscal policy measures. The latter include the research by Shah (1984) on the United States market or by Chatziantoniou, Duffy & Filis (2013) on the one in the UK. Furthermore, few studies investigated a simultaneous impact of monetary and fiscal policy measures on stock market performance. The analysis of the existing research proves the above influence is possible either through direct or indirect channels. This chapter provides an analysis of the existing studies on the given issue on the London Stock Exchange.
Monetary Policy and Stock Market Performance
The research on the impact of monetary policy measures on the stock market is typically based on one of the two approaches: VAR models or event studies. The choice between these methods depends on the time, interests and variables that researchers wish to control (Bredin et al. 2009).
The study by Bernanke & Kuttner (2005) is fundamental to research the impact of monetary policy measures on the stock market. It is inspired by the notion that through affecting the federal funds rate, monetary policy influences asset prices and asset returns. The scholars used a VAR model to estimate the future interest rates, returns, and dividends. The research found out that an unanticipated increase in the federal funds rate led to a rise in stock prices, and this effect was manifested through expected excess returns. The researchers also pointed out that differences in stock market responses to policy changes were sector and industry-based. The authors emphasized that if monetary neutrality remained, the long-run impact of monetary policy actions on stock prices would be negligible. Their results suggested that a restrictive monetary policy lowered stock prices either through increasing the riskiness of stocks directly or through reducing the willingness of investors to bear risks.
Wang & Mayes (2013) analyse the effect of monetary policy interest rate announcements on the stock markets of New Zealand, Australia, the United Kingdom, and the euro area. Their study incorporates event-study methods to evaluate stock price reactions to positive and negative interest rate surprises. In their analysis, they follow Bernanke & Kuttner (2005), who have used a short-window event-study analysis. Their study found out that in the United Kingdom and in the euro area, the response to surprise interest rates on the stock market was generally negative. Thus, instead of stimulating the economy, unexpected downward interest rates caused pessimistic spirits. In addition, their study suggested that the investigation of stock market responses to monetary policy changes in the United Kingdom depended largely on the chosen time period. For example, it was insignificant during the first two years of repo rate announcements that began in June 1997. Wang & Mayes (2013) explained this through suggesting that the market might have been unable to anticipate projected policy changes.
The study by Gregoriou et al. (2009) is focused on examining the effect of anticipated and unanticipated interest rate changes on aggregate and sectoral stock returns in the United Kingdom. In their research, they follow Bernanke & Kuttner (2005), who have decomposed the federal funds rate change into expected and unexpected, and have discovered that unanticipated monetary policy tightening had a negative effect on the American stock market. Similarly, Bredin et al. (2007) used this approach in relation to the United Kingdom stock exchange to demonstrate that unpredicted monetary policy changes had a significant impact on aggregate and sectoral stock returns. However, the study by Gregoriou et al. (2009) departs from the given suggestion in its use of time-series and panel-data regression with a GMM estimator. The scholars used data from seventy FTSE industrial subsectors to measure aggregate and sectoral stock returns and the rate of futures contracts based upon the three-month LIBOR rate as a proxy for market expectations for the period from June 1999 to March 2009. Their analysis demonstrated that both anticipated and unanticipated monetary policy changes made a significant impact on stock market returns. They found out an important change in the stock market reaction to higher interest rates: although the stock market had reacted negatively to higher interest rates before the credit crisis, the relationship between stock returns and interest rates became positive during it. Gregoriou et al. (2009) concluded that this finding suggested that an expansionary monetary policy was incapable of reversing the negative trend in stock prices.
The study by Bredin et al. (2007) investigated the impact of the UK monetary policy on stock returns. They used the event-study analysis to evaluate aggregate and sectoral stock returns changes in response to varying monetary policy measures. Policy rate expectations are measured through futures market data. Their study identified that stock returns response to monetary policy surprises was persistent and negative, being manifested through a decline in futures excess returns.
Ioannidis & Kontonikas (2006) investigated the impact of monetary policy on stock returns in thirteen OECD countries in 1972-2002. Their study included interest rate variables and spreads as indicators of monetary policy, which was in line with the previous studies. The authors also used a binary dummy variable to account for changes in the discount rate administered by the central bank under a restrictive and expansive monetary policy. They found out that in 80% of countries under analysis, periods of restrictive monetary policy were associated with simultaneous declines in the stock market value. Furthermore, the future stock returns would be also affected negatively under these circumstances. The authors suggested that monetary policy measures based on interest rates may be used to forecast expected stock returns. The scholars examined countries with different monetary policy frameworks, such as an explicit inflation target (as adopted in the United Kingdom). Their findings suggested that a restrictive monetary policy negatively affected stock market values regardless of the monetary framework adopted by the government.
Cassola & Morana (2002) analysed the role of the stock market in the transmission mechanism of the euro area. Specifically, their focus was put on the issues whether central banks should take financial market indicators into account when developing economic policy measures, and whether a price-stability-oriented monetary policy is also financial-stability-oriented. Their study used quarterly data on inflation rates, short-term interest rates, real M3 balances, bond yield, and real stock market price index during the period from 1980 to 2000. They concluded that real output changed due to changes in the stock market (for example, stock market disequilibrium). Cassola & Morana (2002) suggested that the cyclical behaviour of the stock market in the euro area could be explained by monetary policy shocks. Furthermore, they stated that while monetary surpluses had a strong impact on inflation, their effect on the stock market was temporary only; therefore, monetary policy aimed at stock market stability could be incompatible with the one being price-stability-oriented. However, Cassola & Morana (2002) also pointed out that monetary policy that the latter might have a beneficial impact on the stock market.
Eichengreen & Tong (2003) investigated the tendency of stock market volatility to display a U-shaped pattern from a long-term perspective. They analysed stock markets of twelve countries, including the United Kingdom, to estimate the above tendency and used the GARCH model with spline functions to calculate volatility rates. They conducted research several times in developing countries and concluded that stock market volatility in advanced economies followed a U-shaped pattern in the long run. For example, in the United Kingdom, volatility first fell and then turned back up in the recent decades. Eichengreen & Tong (2003) suggested that monetary policy and international financial integration could be used to explain this pattern. They asserted that the nature of financial regulations was important for stock market volatility. Additionally, they found out that the credibility and behaviour of monetary policy under a certain exchange rate regime were decisive for the volatility of financial market outcomes.
The research by Joyce, Releen & Sorensen (2008) reviewed major instruments and yield curves that could be employed to evaluate the expectations of stock market participants with respect to United Kingdom monetary policy rates. The study was inspired by the assumption that stock market’s interest rate expectations produced an impact on lending and borrowing rates among consumers and businesses, being important for the transmission mechanism of monetary policy to the economy. They evaluated interest rates derived from various financial instruments for the period from October 1992 to March 2007 (excluding the period of the financial turmoil that began in the summer of 2007). The study found out that interest rate expectations derived from yield curves that did not embody liquidity risk premiums or material credit could be used to estimate financial market expectations of the bank rate. However, the primary message of this research was that it was not wise to rely on a single forecasting method; it was rather useful to use multiple methods in determining financial market expectations.
The research by Lilholdt & Wetherilt (2004) analysed the ability of financial markets to forecast interest rate changes in the United Kingdom over the period from 1975 to 2003. This study was inspired by the suggestion that improvements in the given issue could be caused by the greater transparency of monetary policy or improved credibility of the Bank of England. Another question was whether the ability of financial markets to predict interest rates accurately improved after inflation targeting introduced in 1992. In addition, during the selected time period, the monetary policy regime changed from monetary (1975-85) to exchange rate targeting (1985-92), and then to inflation one (1992 and on). The study researched that the predictability of the Bank of England improved significantly over the analysed period. However, Lilholdt & Wetherilt (2004) also found out that the predictability of monetary policy rates did not improve gradually. Thus, there must have been some structural breaks, which the authors failed to identify.
The study by Bordo, Dueker & Wheelock (2007) evaluates the connection between monetary policy and stock market booms and busts in the United States, United Kingdom, and Germany in the twentieth century. The research is linked to the one by Bernanke and Kuttner (2005), who have discovered that monetary policy measures can affect stock market prices in the long run. Therefore, the performance of asset markets depends on monetary policy regimes and rates. Investigating both interwar and post-World War II periods, Bordo, Dueker & Wheelock (2007) indicated that stock market booms started when GDP growth was above average and ended when it declined. This study provides an interesting account of the United Kingdom’s economic history, especially with respect to monetary policy changes and stock market fluctuations. Based on the analysis, the authors concluded that inflation-adjusted stock prices had reached their lowest point in 1920 and started to increase after a decline in CPI in the country. A slower rate of growth in UK stock prices until the onset of the Great Depression was linked to lower output growth rates and tighter monetary policy. During the 1970s, when the United Kingdom suffered from high inflation rates, a large stock market decline faced the country. Bordo, Dueker & Wheelock (2007) investigated this association between stock market booms and busts and monetary policy rates by using a Qual-VAR model to estimate post-war data. Their study found out that long-term interest rate shocks produced a negative impact on both United Kingdom stock prices and market conditions; indeed, it explained the stock market boom in the 1990s. Money supply and short-term unanticipated interest rate changes produced little or no impact on the stock exchange in the United Kingdom. Furthermore, the scholars indicated that there was a substantial degree of the mutual impact of the United States and United Kingdom stock markets. In addition, Bordo Dueker & Wheelock (2007) found out that periods of low inflation rates were associated with stock market booms in all three countries analysed in the study. They recommended that in order to promote equity market stability, policymakers should take measures to induce financial markets to reduce inflation risk premiums.
In their research, Bernanke & Gertler (2000) analyse the implications of asset price volatility on monetary policy. Their study demonstrates a close link between asset prices and inflation. Bernanke & Gertler (2000) based their research on United States and Japan data and showed that in order to achieve general macroeconomic and financial stability, policymakers should concentrate on flexible inflation targeting. The study demonstrated that asset prices and stock market movements were relevant to monetary policy, due to they carried inflationary or disinflationary pressures. The primary goal of policy in this case was to target inflation to ensure stability. Thus, policies aimed directly at the stock market were ineffective. Similarly, the study by Rigobon & Sack (2004) based on United States data discovered that an increase in short-term interest rates produced a decline in stock prices and led to an upward shift in the yield curve. However, this effect is manifested in the short run only.
The research by Bredin et al. (2009) evaluates the stock market response to international monetary policy changes in the United Kingdom and Germany. They used the event-study analysis to evaluate the impact of monetary policy surprises on stock returns. Interestingly, their study discovered important spillover effects, since unanticipated changes in the United Kingdom monetary policy produced a significant negative impact on sectoral and aggregate stock returns in Germany. On the other hand, expected and unexpected changes in the monetary policy in the euro area did not produce a significant impact on stock returns in the United Kingdom. These findings confirm the ones resulting from a similar study conducted by Bredin, Caroline & Gerard (2005).
Fiscal policy and stock market performance
Little attention has been paid to the effects of fiscal policy on stock market performance. The available studies incorporate United States data; however, the majority of them are based on the analysis of international ones. Some exceptions to the established tradition to evaluate economic effects on the stock market through the prism of monetary policy include the study by Shah (1984), who has constructed a theoretical model to evaluate the stock market response to the government expenditure shock, Razin (1991), Chatziantoniou, Duffy & Filis (2013), Laopodis (2009), Da, Warachka & Yun (2012), and Tavares & Valkanov (2001).
Chatziantoniou, Duffy & Filis (2013) attempted to bridge the gap in evaluating the joint impact of monetary and fiscal policy on stock market performance. The study used stock market and economic policy data from Germany, United Kingdom, and the United States. The scholars indicated that both policies affected stock market performance via direct or indirect channels. More importantly, their interaction is even more important in explaining stock market data. The study used the structural VAR model, which was in line with the previous researches assessing the impact of monetary policy on the stock market. Chatziantoniou, Duffy & Filis (2013) found out that a positive government expenditure shock generated a decline in the stock market in the UK. In line with the previous studies, their research suggested that a positive interest rate change produced a decline in the stock exchange. Besides, fiscal and monetary policies affected the UK stock market through direct channels. These results are contradictory to the theoretical model constructed by Razin (1991), who has attempted to evaluate the international stock market response to changes in government spending. Specifically, the scholar has postulated that an increase in the latter causes a rise in equilibrium return on domestic and foreign equity.
The study by Tavares & Valkanov (2001) evaluates the effect of taxes and government spending on quarterly returns of stocks and government and corporate bonds in the United States over the period from 1960 to 2000. They pointed out that an increase in tax receipts as a share of GDP lowered annualised expected returns, both annually and quarterly. The impact of taxation was similar in relation to stocks and bonds. An increase in government spending made a positive effect on bond returns in the short run. This result contradicts the findings by Chatziantoniou, Duffy & Filis (2013) and is in line with the theoretical model constructed by Razin (1991). However, Tavares & Valkanov (2001) stated that their findings on the government spending effects on the stock market were significant only for analysing the bond market. Therefore, it is possible that the overall impact is similar to that in the United Kingdom. The study also concluded that fiscal policy changes constituted 3-4% of variations in unexpected abnormal stock returns and 8-10% in unpredicted excess bond returns. The study also evaluated the joint impact of fiscal and monetary policy on the United States stock market. Tavares & Valkanov (2001) found out that there was no qualitative variation in the effect produced by fiscal and monetary policy changes on stock market performance, assessing their influence jointly. Another contribution to researching this issue in the United States was made by Laopodis (2009), who suggested that the past budget deficits negatively affected stock returns. Due to this, markets were inefficient in incorporating information about the future fiscal policy changes.
Economic policy effects on the stock market were assessed based on the United Kingdom and international data. The existing studies suggest that the primary effect made by a restrictive monetary policy changes is a decline in asset prices and overall stock market performance. Due to the fact that research on this issue is limited to several empirical studies, it can be proposed that the thorough evaluation of the joint impact of fiscal and monetary policy on the United Kingdom’s stock market should be conducted. Specifically, it is of interest whether the British stock market is efficient in incorporating upcoming fiscal policy changes, and whether it demonstrates similar patterns of reaction to monetary policy changes announcements. The previous research works suggested that VAR models and event-studies could be both used to assess the effect of anticipated and unanticipated fiscal and monetary policy changes on stock market performance in the United Kingdom.