Stock market returns and monetary policy. Identifying the effect of FED’S forward guidance on the stock market.

Abstract

This paper investigates the relationship between the federal funds rate and the S&P 500 index using a vector autoregression (VAR). The VAR model with eight lags suggests that changes in the federal funds rate have a statistically significant impact on the S&P 500, with a one percentage point increase in the federal funds rate associated with a decrease in the S&P 500 of approximately 0.62%. Also 2 dummies were used to determine the effectiveness of forward guidance on the stock market. In the first dummy all the dates where forward guidance language was used, in the second dummy only dates with economic uncertainty where used. The results suggest that forward guidance only has significant effect on equity prices in times of economic uncertainty and if it manages to change GDP growth expectations.