06
JUN 2016

14:15 - 15:45
IWH Research Seminar

Monetary Policy and Asset Mispricing

This paper investigates, whether conventional interest rate policy of central banks is a suitable instrument to attenuate excessive mispricing in stocks as suggested by the proponents of a 'leaning against the wind' (LATW) monetary policy.

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Kerstin Bernoth  (Deutsches Institut für Wirtschaftsforschung e.V.)
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IWH conference room
Kerstin Bernoth

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Professor Dr Kerstin Bernoth is Deputy Head of the Department Macroeconomics at the German Institute for Economic Research (DIW Berlin) and Professor of Economics at the Hertie School of Governance.

This paper investigates, whether conventional interest rate policy of central banks is a suitable instrument to attenuate excessive mispricing in stocks as suggested by the proponents of a "leaning against the wind'' (LATW) monetary policy. We argue mispricing can arise for two reasons: (i) from false subjective expectations of investors about future fundamentals and equity premia, and (ii) from the inherent indeterminacy in asset pricing in line with rational bubbles under objective expectations. Employing a partial equilibrium asset pricing model, we show that the response of the excessive stock price component to a monetary policy shock is ambiguous in both the short- and long-run and depends on the nature of the mispricing. Subsequently, we evaluate the scope for a LATW policy empirically by employing a time-varying parameter VAR with a flexible identification scheme based on impact and long-run restrictions using data for the S&P500 index from 1962Q1 to 2014Q4. We find that a contractionary monetary policy shock in fact lowers stock prices beyond what is implied by the response of their underlying fundamentals.

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