The Federal Reserve Board and the Stock Market Bubble
The Relationship is More Complex Than it Appears
The stock market rose to unprecedented valuations in the late 1990 and was widely considered to be a bubble. The Federal Reserve Board has come under severe criticism recently for causing the bubble and has felt compelled to defend its record. Monetary policy has long been considered a major factor driving the stock market P/E. But how monetary policy impacts the market is more complex than the Federal Reserve Board and its critics realize, and both have made major analytical errors. A simple adaptive behavioral model that uses the percent of the time the market has been in a bull market over the prior twenty years as a measure of the risk premium, as well as interest rates and inflation, demonstrates that an S&P 500 P/E of over twenty is justified and why the relationship between interest rates and the market P/E underwent structural changes in the late 1950s and 1990s. It also shows that if the Federal Reserve Board had tried to prick the 1990s market bubble they would have had to raise rates enough to severely damage the economy. Results from the model also carry major implications for the future relationship between monetary policy and the stock market.