Can Monetary Policies Inflate a Stock Market Bubble? A Regime Switching Model of Periodically Collapsing Bubbles

Monia Magnani ()

No 24231, BAFFI CAREFIN Working Papers from BAFFI CAREFIN, Centre for Applied Research on International Markets Banking Finance and Regulation, Universita' Bocconi, Milano, Italy

Abstract: We study whether and how monetary policymakers may have contributed to inflate asset price bubbles and in general what are the potentially complex, non-linear linkages between short-term policy rates and the size and expected durations of equity bubbles. In particular, we extend empirical models of periodically collapsing, rational bubbles to test whether and to what extent the long cycle of rates at the zero lower bound and of quantitative easing policies may have increased the probability of bubbles inflating and persisting, with special emphasis on the US stock market. We find that the linkages between S&P returns and rate-based indicators of monetary policies contain evidence of recurring regimes that can be characterised as one of a persisting vs. one of a collapsing bubble. Moreover, the probabilities of financial markets transitioning from a bubble to a state of (partial) collapse turns out to depend on both the initial, relative size of the bubble and on monetary policy indicators. This implies that an easier (tighter) monetary policy will inflate (deflate) a bubble through a simple, regression-style effect, but also yield a non-linear, “concave” effect by which sufficiently low (high) rates are enough for a bubble to inflate (deflate) with high probability. Besides fitting the data, the resulting, parsimonious, regime switching models provide an accurate and economically valuable predictive performance, even when transaction costs are taken into account.

Keywords: Rational bubbles; monetary policy; stock returns; regime switching; forecasting. (search for similar items in EconPapers)
JEL-codes: C58 E52 G12 G17 (search for similar items in EconPapers)
Pages: 80
Date: 2024
New Economics Papers: this item is included in nep-cba and nep-mon
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