Abstract
This paper empirically explores the short- and long-run effects of fiscal and monetary policies on US stock returns and tests the validity of market efficiency. The results support the presence of a strong long-run (equilibrium) relation binding stock prices with fiscal (but not monetary) policy. Further tests assign a dominant role to fiscal policy as a main force driving the overall equilibrium relation with the stock market. Estimates from error-correction models corroborate the existence of robust long-run relation and further suggest that past fiscal (but not monetary) policy actions exert significant short-run effects on current stock returns. A similar verdict emerged from alternative estimates in which fiscal policy actions anticipated from an ex ante equation continue to support a significant lagged relation with current stock returns. These results provide consistent evidence that important effects of fiscal policy are transmitted to the real economy through the stock market. Moreover, the results for fiscal policy appear at variance with market efficiency. However, transaction costs and other well-known modeling caveats may impede implications for profitable investment strategies.
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Notes
For a lucid survey of the market efficiency hypothesis, see Yen and Lee (2008).
These studies, among others, suggest that fiscal policy affects stock returns by influencing several factors like risk premium, corporate earnings, and long-term interest rates. We perform two steps to investigate through which of these channels the effect is transmitted. First, we estimate the impact of fiscal policy on each of these variables. The results indicate the statistical significance of risk premium (with five lags, F = 14.17) and the long-term interest rate (with one lag, t = 2.39), each of which are statistically significant at the 5 % level. In the second step, we control for both of these significant variables in the stock price model estimated below.
See, for example, Bordo and Wheelock (2004), Ehrmann and Fratzscher (2004), Bernanke and Kuttner (2005), Gregoriou et al. (2009), Christiano et al. (2010), and Airaudo (2013). These authors may have assumed away fiscal policy based on the Ricardian neutrality proposition. Yet, enduring controversy surrounds this proposition both theoretically and empirically as evident in Evans (1987), Darrat (1987), Liederman and Blejer (1988), Becker (1997), and Garcia and Ramajo (2005).
Cyclically-adjusted budget deficits represent the net budget position if the economy were at full employment at the prevailing prices. As such, cyclically-adjusted (in contrast to actual) budget deficits better measure the stance of fiscal policy since they filter out movements in actual deficits resulting from the impact of business cycles. For a useful discussion of the nature and policy implications of cyclically-adjusted budget deficits, see Sterks (1984), and Grier and Neiman (1987).
We use two unit-root tests to ensure the reliability of our verdicts on stationarity.
Additional lags of the error correction term are redundant since they are already reflected in the distributed lags of the independent variables.
The FPE criterion minimizes one-step-ahead prediction errors and searches for a compromise between the predictive power of the model and its complexity as measured by its lag orders.
The model initially included a dummy variable to account for the recent global financial crisis. However, the dummy variable fails to achieve statistical significance and was thus removed.
For consistency, we further investigated if the lagged monetary policy variables in model (1) are also strictly exogenous. Similar to lagged fiscal policy variables, the Hausman test also fails to reject the null of strict exogeneity for the monetary policy variable at the 10 % level (F-statistic = 0.71, the corresponding F value = 0.51). We are indebted to an anonymous reviewer for alerting us to this and other important aspects of our analysis.
Results in Table 3 indicate that inflation exerts a strongly negative effect on stock returns. However, the available evidence on the sign of theoretical relation between inflation and stock returns is largely mixed. For example, while Fama (1981) finds a negative relation between inflation and stock returns, Wei (2010) supports a positive link using alternative but plausible model specifications.
Data on high-employment spending and tax receipts are unavailable. Thus, we estimated these data as the residuals from regressing the actual figures on a constant, seasonal dummies and current and lagged real GDP. Insofar as the effects of current and lagged real GDP are purged, the estimated residuals seem reasonable proxies for the unavailable high-employment figures.
Note that the balance of trade variable proves stationary in first differences and is thus entered in that format in model (2).
We also estimated models 2 and 3 jointly by the seemingly-unrelated regressions (SUR) method and the results are very similar to those reported in the text based on separate estimations; very likely an outcome of a highly insignificant correlation between the two sets of residuals (=−0.0136, t value = 0.19). As was done with model (1), we checked if results from model (3) are not parsimonious by deleting insignificant variables and re-estimating. Again, our conclusions proved insensitive to a possible over-parameterization issue.
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Acknowledgments
The authors are indebted, without implicating, to the Editor and to two anonymous reviewers for several insightful comments and suggestions. An earlier draft of this paper was presented to the South-Western Finance Association 2014 meeting held in Dallas, Texas.
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Appendix: variable definitions
Appendix: variable definitions
Variables definition | |
|---|---|
Fiscal policy | \({\text{DBF}}_{\text{t}} = \left( {1 - {\text{L}}} \right){\text{BF}}_{\text{t}}\), where BF is the cyclically adjusted federal budget deficit |
Monetary policy | \({\text{DDMB}}_{\text{t}} = \left( {1 - {\text{L}}} \right)^{2} {\text{Log}}\;{\text{MB}}_{\text{t}}\), where MB is the monetary base |
Short-term interest rate | \({\text{DTB}}_{\text{t}} = \left( {1 - {\text{L}}} \right){\text{Log}}\;{\text{TB}}_{\text{t}}\), where TB is the 3-month treasury bill rate |
Inflation | \({\text{DDIF}}_{\text{t}} = \left( {1 - {\text{L}}} \right)^{2} {\text{Log}}\;{\text{CPI}}_{\text{t}}\), where CPI is the consumer price index (Urban, all items) |
Stock price | \({\text{DSP}}_{\text{t}} = \left( {1 - {\text{L}}} \right) {\text{Log}}\;{\text{S}}\& {\text{P}}500_{\text{t}}\), where S&P500 is the standard and poor’s common stock composite price index |
Industrial production | \({\text{DIP}}_{\text{t}} = \left( {1 - {\text{L}}} \right) {\text{Log}}\;{\text{IP}}_{\text{t}}\), where IP is the industrial production index |
Balance of trade | \({\text{DDBT}}_{\text{t}} = \left( {1 - {\text{L}}} \right)^{2} {\text{Log}}\;{\text{BT}}_{\text{t}}\), where BT is the balance of trade |
Long-term interest rate | \({\text{DGB}}_{\text{t}} = \left( {1 - {\text{L}}} \right) {\text{Log}}\;{\text{GB}}_{\text{t}}\), where GB is the 10-year government bond yield |
Risk premium | \({\text{RP}}_{\text{t}} = \left( {1 - {\text{L}}} \right)({\text{DBAA}}_{\text{t}} - {\text{DTB}}_{\text{t}} )\), where DBAA is the first difference of the BAA Bond rate and DTB is defined as earlier |
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Mbanga, C.L., Darrat, A.F. Fiscal policy and the US stock market. Rev Quant Finan Acc 47, 987–1002 (2016). https://doi.org/10.1007/s11156-015-0528-y
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DOI: https://doi.org/10.1007/s11156-015-0528-y
Keywords
- Market efficiency
- Fiscal and monetary policies
- Cointegration
- Error corrections
JEL Classification
- G14
- E44