Nonlinear Dynamics in Monetary Policy-Fueled Stock Market Bubbles

Monia Magnani and Massimo Guidolin

No 25252, 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 the complex, non-linear linkages between short-term policy rates and the size and expected durations of equity bubbles. 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 emphasis on the US stock market. We find that the linkages between S&P returns, and ratebased indicators of monetary policies contain evidence of recurring regimes that can be characterized 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, starting from low rates, rate hikes may at first inflate bubbles before contributing to their bursting, when rates are pushed above a critical threshold. Besides fitting the data, the resulting, parsimonious, regime switching models provide accurate and economically valuable recursive out-of-sample 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: 70
Date: 2025
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