Monetary Policy and Stock Returns

The Standard & Poor stock market composite index is examined to determine how much of the variance in returns can be explained by monetary policy. The note employs the econometric technique of generalized forecast error variance decomposition developed by Koop et al. (Journal of Econometrics, vol. 74, 1996, pp.119–47) and Pesaran and Shin (Economics Letters, vol. 58, pp.17–29). Unlike the traditional orthogonalized decomposition, the generalized version is invariant to the ordering of the variables in the underlying vector autoregression. The results provide important information about the relationship between monetary policy and the stock market.