There has been much discussion that how money supply affects stock return. As Jensen, Johnson and Bauman (1997) mentioned, "Federal Reserve monetary policy is widely recognized as having a significant influence on security returns". Following that, a great many of previous researchs have been done to check whether the changes of money supply have a positive or negative relationship with stock returns. Among them, Sprinkel (1964), Homa and Jaffee(1971), and Hamburger and Kochin (1972) argued that there is a positive relation between money supply and stock return. While, Jensen and Johnson (1995) found that a decrease in discount rate will lead to a higher rate of return of stocks. Furthermore, according to recent work by Bernanke and Kuttner (2005), with an unexpected 25-basis-point cut in Federal funds rate a 1% increase of overall stock indexes will take place. Thus, this essay will attempt to explain the process that how stock returns are influenced by the changes of money supply and evaluate the empirical validity of the inverse relationship between money supply and stock returns.
In order to demonstrate this, firstly, some theoretical hypotheses will be shown to explain the process that stock prices are influenced by money supply. In addition, two possible relations between money supply and stock return changes will be assessed with the help of some early studies available.
2.0 Theoretical Hypotheses related to the process of money supply
One of main explanations for how stock prices are influenced by money supply may be the liquidity hypothesis. Excessive money supply will attribute to high demand for bonds, thus lower rate of return of bonds will occur. Following that, investors will change from capital market to equity market. Finally, stock price may go up. Few studies related to this hypothesis were found, and this may be the reason that most investors have a preference of equity market. For them, they won't choose bonds except some risk-avoiding considerations in portfolios.
Another explanation related the process of money supply is the expected inflation hypothesis. According to Peace and Roley (1983), when money supply rises quicker than was expected, this will lead to higher inflation and the market rate of interest rate will also follow to go up. Thus, stock return may decline. This argument is also supported by Summers (1981) in his analysis of firm data. Stock price was sensitive to any changes in the market, especially for monetary changes. When excess money was found in the market and inflation rate continues to rise, with the expectation that a tighter monetary investor will sell their stocks, thus stock prices will go down (Rozeff, 1975).
However, according to the numerous tests of Sprinkel (1964), they found that there is a positive correlation between some stock return and the rate of inflation. This may be the reason that investors' tolerance of risk was undermined and they intended to excavate more profits from the market. Further evidence which was found by Bernard and Frecka (1983), they also found stock prices are positively related to inflation. Although those studies suggest that there is a positive relationship between stock return and money supply, dominant researchers support that unanticipated changes in money supply have an inverse relation with stock prices.
3.0 Assessment of inverse relationship between money supply and stock returns
Before evaluating the previous studies, it should be noted that in practise, when researchers analysis the future changes of monetary policy, discount rate variation are recognized as very important signals (Jensen, Johnson and Bauman, 1997). This is because the discounting framework will contain both the real interest rate and expected rate of inflation.
The initial analysis of the relationship between the stock return and money supply using signal of discount rate is conducted by Woud (1970). He used data removing systematic components, and checked whether changes in discount rate or monetary policies have a 'psychological' impact on public investment activity. He found that there is a strong evidence of an announcement effect that when discount rate decreases, stock market will react positively, and when discount rate increases, negative performance will be on the stock market. This study critically examined the effect of discount rate changes to stock market. One possible drawback may be that Woud just used bank discount rate to analysis the volatility of one index-Standard and Poor's 500 daily stock index. Probably more other index date using will enable the test more accurate. In addition, the implementation of discount rate changes is not universally accepted. Several later studies suggest that rate changes can be predicted, thus it may not influence the stock return.
Later, starting from the efficient frontier-the minimum variance portfolio, Bodie (1976) measured the effectiveness of using common stocks as a hedge against inflation. The notion to the test is that stock market and money supply are inversely related. In this study, the author attempted to find that how much the uncertainty of real return will be reduced by combining a nominal bond with a "representative" well-diversified portfolio of common stocks. In the end, the results of regression suggest that, at least in the short run, inflation is inversely related to the real return on equity. Thus investor may sell common stocks short to hedge against unexpected inflation. The study, from inflation and application side, proves the negative relation between stock price and money supply. The disadvantage of the test is probably that inflation rate (which use the value of the Consumer Price index) may have a lag-effect to reflect the changes in money supply. In a related study, Fama and Schwert (1977) used various the data during the 1953-1971 periods and tested that whether several different assets were able to hedge against the expected and unexpected components of the inflation rate. They found that future stock and bond returns are inversely related to the expected inflation and only private residential real estate can be used as a complete hedge against both expected and unexpected inflation during this period.
Urich and Wachtel (1981) made use of data of weekly money supply announcement to test stock market reaction. Moreover, three ways of how market interest rate was affected by announcement of money supply were explained. They found a very quick reaction of financial market towards the announcements of weekly money supply, and when monetary supply increases was emphasised, the reaction was biggest. This study certify again the existence of 'announcement effect', and provide further evidence of the relation between monetary changes and market interest rate. However, that no links were put on to stock market might be one weakness. Following that, focusing on a very short-period money changes of both expected and unexpected, Pearce and Roley (1983) applied similar weekly data to test whether there is correlation between money changes and common stock prices. They found only unanticipated monetary changes will enable stock price respond, and the relation between them is negative. They also discovered that the reaction of market will be finished early in the relevant trading day. In a similar study, Smirlock and Yawitz (1985) categorized the expected discount rate changes from unexpected changes. Based on the hypothesis that, if the security market is efficient, there will be no announcement effects for the expected discount rate changes, while announcement effects will happen in the unexpected changes, they found that for pre-October 1979 period there is no evidence of such effects on market interest rates, and for post-October 1979 period the effects is happen in the unexpected discount.
In contrast to Smirlock and Yawitz (1985), Cook and Hahn (1988) found strong evidence of announcement effects both before and after October 1979. They firstly divided discount rate announcements during 1973 to 1985 period into three types in the light of the language contained in the announcement. Then they discovered that during this period two types of announcements were mainly used to guide movements in the funds rate and impact the bill rates, and weak evidence of one type of announcements were found to signal the funds rate changes and also failed to have an influence on bill rates in the period of pre-October of 1979. There are two aspects of their results which may differ from previous studies. The first one is that, comparing with the study of Smirlock and Yawitz (1985), strong evidence of announcements on Treasury bill rates was found in the pre-October 1979. The other one is that the response to 2 types of discount rate announcements, according to their classifying, was especially strong.
Using a longer period data from 1961 to 1991, Jensen and Johnson (1995) found that higher and stable stock returns were received following the discount rates decreases, while lower and volatile returns would be given to ones following the discount rates increase. Their results also indicate that there will be a significantly lower variability in returns following the period of discount rates decreases than that of following the period which rates increase. Furthermore, the results of recent study of Bernanke and Kuttner (2005) suggest with an unexpected 25-basis-point cut in Federal Federal funds rate, a 1% increase of overall stock indexes will take place. They also explain their results that monetary policies affect stock returns. The reason of that is the changing expected equity premium which may come from two ways: the riskiness of stocks and willingness of stock investors to bear risk.
4.0 Conclusion
This essay has demonstrated that the process that how monetary supply affects stock returns and also assessed the previous studies. Although not all early studies support the statement that "Unexpected changes in money supply and stock returns are inversely related", using more data and more detail analysis, recent studies found the evidence of the statement. Therefore, it can be concluded that monetary supply does have a negative relation with stock returns according to the recent research trends.
