Monetary Policy and the Prediction of Stock Returns

Estimating the response of stock returns to monetary policy changes is challenged by the reverse causality issue that monetary policy might react to soaring stock prices as a tool to defuse asset price booms. This paper applies the novel Continuous Wavelet Analysis to stock returns and monetary policy indicators, which segments and identifies causal and reverse causal, lead and lag relationships between the two time series for different historical periods and frequencies. Empirical results provide evidence that at quarterly to yearly frequencies, Fed's policy goal was anti-inflationary oriented to fight stock market bubbles around 1998 to 2002, while during the 2008 financial crisis,easing monetary policy has led to recovery of the market. The 2001 economic crisis was also discernible according to significant correlation between policy and returns at higher frequencies. The Nadaraya-Watson Kernel regressions further confirm that there exist threshold effects under different market conditions.