Quantitative easing and US stock prices : A study on unconventional monetary policy and its long-term effects on stocks

Abstract: Conventional monetary policy has traditionally been conducted through changes in the interest rate, in order to adjust the economy back to equilibrium by targeting stable inflation and prices. However, after the financial crisis in 2008, many central banks found themselves in the Zero Lower Bound, where interest rates were close to zero and conventional expansionary monetary policy was therefore ineffective. In order to combat this problem, central banks turned to quantitative easing (QE), which essentially boils down to large-scale asset purchases (LSAP’s) pursued by the central bank, resulting in increased liquidity in markets, with the purpose of stimulating the economy. This paper analyses the Federal Reserve Banks (FED) LSAP’s and how this has affected stock prices in the US. In doing this, the size of the FED’s balance sheet is used, since it directly captures the size of the LSAP’s and therefore acts as measurement of QE as conducted by the FED. Regarding stock prices, the Standard and Poor’s 500 stock index is used, which represents 500 major firms in the US. The analysis is carried out by using the Error Corrected (EC) version of the Autoregressive distributed-lagged model (ADL), with the purpose of evaluating the existence of a long-run relationship between the variables in the econometrical model. The results show that there is a statistically significant positive long-run relationship between the FED’s balance sheet and stock prices.