Ebook Interactions between business cycles, financial cycles and monetary policy: stylised facts
The spectacular rise in asset prices up to 2000 in most developed countries has attracted a great deal of attention and reopened the debate over whether these prices should be targeted in monetary policy strategies. Some observers see asset price developments, in particular those of stock prices, as being inconsistent with developments in economic fundamentals, ie a speculative bubble. This interpretation carries with it a range of serious consequences arising from the bursting of this bubble: scarcity of financing opportunities, a general decline in investment, a fall in output, and finally a protracted contraction in real activity. Other observers believe that stock prices are likely to have an impact on goods and services prices and thus affect economic activity and inflation.
These theories are currently at the centre of the debate on whether asset prices should be taken into account in the conduct of monetary policy, ie as a target or as an instrument. However, the empirical link between asset prices and economic activity on the one hand, and the relationship between economic activity and interest rates or between stock prices and interest rates on the other, are not established facts. This study therefore sets out to identify a number of stylised facts that characterise this link, using a statistical analysis of these data (economic activity indicators, stock prices and interest rates).
More specifically, we study the co-movements between stock market indices, real activity and interest rates over the business cycle. Assuming that there is no single definition of the business cycle, we adopt an agnostic approach in our methodology.
The traditional approach characterises the cycle as a series of phases of expansion and contraction. Formally, expansion phases are defined as the periods of time separating a trough from a peak; conversely, contraction phases correspond to periods separating a peak from a trough. In this respect, it is vital to define and accurately identify peaks and troughs.
Although this view of the cycle fell out of fashion after the 1970s, it has recently come back into focus thanks to a number of studies, in particular by Harding and Pagan (2002a,b), who proposed a simple method for analysing the concordance between macroeconomic variables. By definition, the concordance index represents the average number of periods in which two variables (eg GDP and a stock market index) coincide at the same phase of the cycle.
The traditional approach defines the business cycle directly by analysing changes in the level of a variable, eg GDP. The modern approach (mentioned above), using the appropriate statistical filtering techniques, enables us to split a variable into two components, one cyclical or short-term, and the other structural or permanent. As its name suggests, the cyclical component has no trend and can be associated with the business cycle. Consequently, we can calculate the correlations between the cyclical components of two variables in order to study the degree of their co-movement (ie the similarity of their profile). However, we show that the structural component of a variable is driven by a trend. Hence, to avoid spurious relationships, we study the growth rate of the structural components. We can also calculate the correlations between the growth rate of the structural components of two variables in order to study their co-movement.
As the notions of concordance and correlation do not have an identical scope, it is useful to use both of these tools when attempting to characterise the stylised facts relating to the business cycle. The first part of this study is devoted to the empirical analysis of the concordance indicator; the second part starts off by describing changes in the variables studied (real activity, stock prices and interest rates) by separating the cyclical (or short-term) components from the structural (or long-term) components, and then compares the variables using the dynamic correlations of their corresponding components (ie cyclical/cyclical and structural/structural).
In both parts, we compare the results obtained on the business and stock market cycles to the monetary policies applied over the period studied: first, we analyse the behaviour of short-term interest rates over the phases of expansion and contraction of real activity and stock prices; and second, we calculate the correlations between the cyclical components of real activity, stock prices and interest rates on the one hand, and the correlations between the structural components of these variables on the other.
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