An innovative way to understand the impact of monetary policy
In this paper, Chari and Henry use stock market reactions to measure the effectiveness of monetary policy in fighting inflation on a cost/benefit basis. They argue that the central issue about disinflation is not how costly it is in the short run, but whether the costs of disinflation, if any, are outweighed by the longer-run benefits.
[S]tock market analysis of disinflation highlights the fundamental issue of net present value. A country’s aggregate share price index is the present value of the expected future profits of its publicly traded firms. Changes in stock prices, therefore, reflect revised expectations about future corporate profits and the discount rate at which those profits are capitalized. Contractionary measures taken to reduce inflation may raise discount rates and reduce profits in the short run. But the reduction in inflation may increase future profits because reducing inflation: (a) raises productivity, and (b) may also reduce discount rates (e.g., equity risk premia) by reducing the variance of expected future profits. The percentage change in the stock market in response to the announcement of a disinflation program removes the temporal dimension of the analysis by collapsing the entire expected future stream of disinflation costs and benefits into a single summary statistic: the present value of the expected net benefits of the program.
For the current situation, their analysis suggests that the US will not experience a quick, low-cost transition from moderate inflation to the Fed’s two-percent target.
Disinflation and the Stock Market: Third World Lessons for First World Monetary Policy
Authors: Anusha Chari, Peter Blair Henry
From: University of North Carolina at Chapel Hill, Stanford University
