The stock market and the Fed

This article investigates the reaction of the Federal Reserve to developments in the stock market. The issue is analysed by first constructing an Index of Stock Price Misalignment (ISPM) in which the fundamental value of the stocks is computed on the basis of the discounted cash flow approach and by then including this index, among the regressors, into a forward looking Taylor rule. In accordance with the descriptive evidence, based mainly on the analysis of the Federal Open Market Committee (FOMC) meetings and public statements, our findings show that the Fed tends to lower the Fed funds rate when stock prices fall below their fundamental value, while there is no evidence of monetary stringency during episodes of exuberance in the stock market.