Assessing the Impact of Federal Reserve Policies on Equity Market Valuations: An Instrumental Variables Approach

Journal of Risk and Financial Management. 2024. Vol. 17. No. 10. Article 442.

Rincon C. J., Darko B. Vukovic

This study investigates the impact of Central Bank interventions on the pricing dynamics of select stock markets. The research utilizes the instrumental variables three-stage least square (3SLS) model approach. It analyses the effects of variations in the Federal Reserve’s balance sheet size across three distinct intervention scenarios: the 2008–2013 Great Recession, the 2020–2021 COVID-19 pandemic periods, and an overarching analysis spanning these timelines. Our methodology includes estimations of the Seemingly Unrelated Regression Equations (SURE), and the results are robust under the two-step Generalized Method of Moments (GMM). Our findings indicate that changes in the size of the Fed’s balance sheet correlate significantly with the pricing of principal U.S. equity market indices. This correlation reflects a time-dependent effect emanating from the Fed’s balance sheet expansion, marking a growing divergence between the adaptability of pricing mechanisms in equity and debt markets. Notably, the Federal Reserve’s interventions during the COVID-19 crisis are associated with an increase of approximately 0.0403 basis points per billion in treasury yields. This research makes a significant contribution to the understanding of financial asset pricing, particularly by elucidating the extent to which interventions in government debt securities engender price distortions in certain equity markets.

Keywords: instrumental variables, quantitative easing, Great Recession, COVID-19, Tapering, Fed’s Balance Sheet