The Fed and Stock Market: A Proxy

and Instrumental Variable

Identification 1

Stefania DAmico* and Mira Farka**2

First Draft May 20, 2002
This draft October 1, 2002

Abstract
Stock market fluctuations are likely to be an important determinant of
monetary policy decisions because of their potential impact on macroecon-
omy. At the same time, innovations in fed fund rates aect stock prices as
they change the expected future real interest rates. In this paper we apply
a new identification procedure, based on proxy and IV variables, to estimate
the contemporaneous relations between stock market and monetary policy
without imposing any exclusion restrictions on the parameters of interest.
Our empirical results indicate: first, that monetary policy responds in a
positive fashion to contemporaneous changes in the stock market, but this
relationship is not significant; second, that stock returns respond negatively
to a positive monetary policy shock and that this response is significant at
1% level. This estimation analysis, while indicating that stock market partic-
ipants react strongly and significantly to monetary policy innovations, seems
to confirm the fact that in the past the Fed has not directly targeted asset
prices in the conduct of monetary policy.
JEL Classification E44, E47, E52
Keywords: Monetary Policy, Financial Markets, Structural VAR, Identi-
fication.
1
We thank Prof. Boivin for endless conversations, generous suggestions and detailed
comments; Kenneth N.Kuttner for detailed instructions and data on monetary surprise;
Faust J., Eric. T. Swanson and Jonathan H. Wright for data on federal fund futures;
Allan D.Brunner, for data on macroeconomic announcements; Prof. Mishkin and Prof.
Dhrymes for specific comments. Finally we thank Amadeu DaSilva and Stefano Eusepi
for their patient support.
2
*Columbia University, email: sd445@columbia.edu; www.columbia.edu/~sd445.
**Columbia University, email: ef158@columbia.edu; www.columbia.edu/~ef158.

1
1 Introduction
The past decade has recorded some interesting and seemingly contradictory
economic phenomena for the US economy. First, an observed increase in
financial wealth particularly in the form of equity holdings; second, a lower
and steadily declining rate of inflation, and third, large increases and rapid
movements in financial asset prices. By the end of year 2000, the total finan-
cial wealth of US households amounted to 36 trillion dollars, with one third
of this financial wealth being held in form of equity holdings. During this
period inflation remained low, with the consumer price index rising at an
average annual rate of 2.2 percent as asset prices continued their remarkable
increase to an all time high. For example, during 1995-1998 period, Stan-
dard and Poors 500 composite index recorded an extraordinary gain of 76%1 .
Fueled by this rise in stock market, the median amount of publicly traded
stocks held by households grew 82.3% in this period, rising from $9,000 in
1995 to $17,500 in 1998.
These developments in financial markets have led many economists and
policymakers to focus their attention in asset prices and their impact in the
macroeconomy. There are several channels through which stock market per-
formance influences macroeconomic activity. First, changes in asset prices
aect the financial wealth of households thereby influencing consumption ex-
penditures. Second, changes in asset prices aect the ability of enterprises
to raise funds for their investment project by changing both the ability of
firms to issue new stock and by altering the value of firms collateral. Third,
asset prices -determined by risk adjusted expected returns- may contain use-
ful information about current and future economic conditions2 . Moreover,
the rapid and positive gains of asset prices in recent years have heightened
concerns about irrational exuberance on the part of the investors, thus redi-
recting attention towards the appropriate monetary policy actions in presence
of a potential asset bubble3 .
1
This data is taken from the 1998 Survey of Consumer Finances, produced by the
Federal Reserve Board.
2
To this end, asset prices may play a valuable indicator role in inflation and output
forecasts (see for example Alchian and Klein (1973), Goodhart (1999), Filardo (2000)).
3
Central Bank should intervene to deflate an asset bubble provied it can properly iden-
tify and puncture the bubble. Although the latter recommendation is hard to implement
in practice (it suggests that monetary authority has superior information relative to other
market participants in being able to identify and deflate the bubble in a timely and well
measured fashion), it nevertheless provides additional incentives for central banks to pay

1
 Because of their potential impact in the macroeconomy, stock market
fluctuations are likely to be an important determinant of monetary policy
decisions. On the other hand, innovations in fed fund rates aect stock prices
as they change the expected future real interest rates and alter the leverage
position of firms. This simultaneous response leads to the endogeneity prob-
lem between fed fund rates and stock returns. In a structural VAR context,
the simultaneous determination of policy rates and stock prices requires iden-
tifying assumptions that do not allow for contemporaneous reactions between
these variables. At best, exclusion restrictions allow identification of one of
them4 . In this paper we apply a new identification procedure that attempts
to overcome these shortcomings allowing the estimation of contemporaneous
relations between stock market and monetary policy 5 . Closely related to the
independent work by Faust et al. (2002a, 2002b), our identification method
departs from existing literature of exclusion restrictions and traditional in-
strumental variables6 .
Our methodology uses proxy and instrumental variables in achieving iden-
tification. Following the influential work of Kuttner (2001) we use changes in
federal fund futures prices rate on the days of FOMC meetings as a measure
of monetary policy surprises. Since the Fed funds futures prices are a natural
market based proxy of expectations on future monetary policy, any change
in the price of the contract on the day of FOMC meetings should capture
unexpected monetary policy actions. On the other hand, we use changes
in S&P500 futures prices on the days of monetary policy announcements to
gauge the response of stock market to monetary policy shocks. In particu-
lar, to provide a precise empirical examination of this response we use a new
dataset consisting of eight years of real-time S&P500 future price quotations.
The simultaneous use of changes in prices of fed funds futures and of
S&P500 futures on the days of policy announcement, allows us to locate a
point in the impulse response function of stock returns to a policy shock.
The point on the impulse response function identifies the additional relation
between the contemporaneous parameters of the model needed to complete
identification.
Since the existence of futures contract in S&P500 is crucial in identifying
close attention to asset price movements.
4
See for example: Farka (2001), Gotto and Valkanov (2001)
5
Rigobon and Sack (2001), in the same context, solve this endogeneity problem through
changes in variance of structural shocks.
6
See Bernanke and Gertler (2000).

2
the response of stock market to a monetary policy shock, the problem of
identification would remain unsolved in the absence of such contracts. To
allow for a more general use of our identification procedure we extend our
technique to address those cases where futures contracts are inexistent or
thinly traded. The method develops an instrument for the stock return vari-
able in the policy reaction function where the instrument is purified from
its correlation with the structural shock. We regress stock returns on mone-
tary policy shocks7 and use the residuals from this regression as instrument
variable for stock returns in the policy reaction function. By construction,
residuals from this regression would be uncorrelated with monetary policy
shocks since we have partialled out the eect of these disturbances on stock
returns and eliminated the endogeneity between asset prices and monetary
policy actions.
The empirical result presented in this paper should be regarded as a
first tentative in estimating the contemporaneous relationships between stock
market and monetary policy under more general conditions and without im-
posing any exclusion restrictions on the parameters of interest. Our empir-
ical results indicate that monetary policy responds in a positive fashion to
contemporaneous changes in the stock market, but this relationship is not
significant. These findings suggest that positive innovations in stock market
elicit tighter monetary policy realized through increases in interest rates. At
the same time, we find that stock returns respond negatively to a positive
monetary policy shock and that this response is significant at 1% level.
The rest of the paper is organized as follows: Section II provides a brief
description of recent attempts in the literature in identifying the simultane-
ous determination of interest rates and stock returns in a structural VAR
model. This section also oers a brief overview of recent work in identifying
policy shocks through federal funds futures contracts. Section III develops
the identification method via changes in fed funds futures and futures con-
tract on stock indices. This section also discusses a generalized version of
the identification procedure through construction of instrumental variables.
Section IV discusses and lends support to our identification assumptions.
Section V presents a detailed explanations about the data and the variables
included in the model. Section VI provides empirical results and analysis.
Concluding remarks and implications for our empirical findings are discussed
7
Similar to the first method, we measure structural monetary policy shocks by fed fund
future price changes.

3
in Section VII.

2 Overview of Recent Literature

The purpose of this section is to review two important and growing strands
of the literature that are closely related to our own work. The first overview
focuses on recent attempts in the discipline to identify monetary policy re-
action functions in a VAR setting augmented with financial variables. The
second overview concentrates on recent work in measuring monetary shocks
through changes in futures of federal funds rate. Since our identification
method depends crucially on price changes of fed funds futures as proper
measure of monetary policy shocks and on price changes in SP500 futures
as reactions of stock prices to monetary policy, a brief review of the growing
work in the area is needed to fully explain our starting assumptions.

2.1 Identifying Monetary Policy Reaction to Stock Re-

turns
Earlier attempts in the literature focusing on the impact of monetary policy
on financial markets have used exclusion restrictions to identify their struc-
tural models (see for example Goto and Valkanov (2000) and Farka (2001)).To
complete identification, these papers assume a contemporaneous recursive re-
lationship between the variables in order to isolate monetary policy shocks.
While these assumptions may hold true when analyzing responses of macro-
economic variables to monetary policy shocks (a large body of empirical work
indicates that monetary policy aects macroeconomic variables with lags),
it may be the case that such exclusion restrictions may not be appropriate
when analyzing the endogenous response of financial markets to monetary
policy shocks at the same time that policy may be reacting to stock market.
Bernanke and Gertler (2000) estimate a forward looking policy rule aug-
mented with contemporaneous changes in stock prices. The forward looking
nature of the model requires the replacement of expectational variables with
realized values of those variables, using as instruments macroeconomic vari-
ables known at time t-1 or earlier. To circumvent the endogeneity problem
that arises from simultaneous responses between stock market and monetary
policy, the paper instruments for contemporaneous changes in stock market
index with lagged values of stock prices. Under the assumption of rational

4
expectations, monetary policy shocks will not be correlated with lagged val-
ues of stock prices. Nevertheless, as Rigobon and Sack (2001) point out in the
context of US economy it is hard to conceive of any instrument [for stock
prices)8 ] that would aect the stock market without aecting the path of
interest rates. Empirical results reported by Bernanke and Gertler demon-
strate that the response of monetary policy to stock market is insignificant
and negative (the reported parameter on stock prices has thus the wrong
sign) indicating that the Fed has not actively sought to stabilize or react to
stock prices.
In a related work, Rigobon and Sack (2001) develop a new identification
method in a structural VAR allowing for simultaneous responses of monetary
policy to stock market. Their analysis attempts to measure the reaction of
monetary policy to an exogenous movement in stock prices controlling for the
influence of macroeconomic shocks. With this specification, any estimated
response of policy to stock returns must be over and above the predictive
power of the stock market in the macroeconomy. In a VAR setting, the
simultaneous determination of interest rates and stock prices poses a great
challenge in identifying monetary policy response to stock market. Since
exclusion restrictions require that either monetary policy does not respond
contemporaneously to stock prices or that stock market is not aected within
the same time period from monetary policy shocks, departing from them
necessitates a novel identification technique.
The identification method employed by Rigobon and Sack uses the het-
eroskedasticity found in interest rates and stock market returns to identify
the reaction of monetary policy to the stock market. The paper identifies
the slope of monetary policy reaction function through regime shifts of the
variance-covariance matrix of the shocks. Identification assumptions require
that monetary policy shocks are homoskedastic across regimes, while allow-
ing for heteroskedasticity of stock market shocks. Regime changes in the
variance-covariance matrix provide the additional equations needed to iden-
tify the estimated response of monetary policy to stock market. Their results
show that monetary policy responds positively (though the estimated para-
meter is small in magnitude) and significantly to stock returns.
Despite the significant contribution of this paper to the literature, some
caveats are in order. As the authors point out, even though regime shifts
8
To this end, our IV method concentrates in constructing rather than finding an
instrument.

5
in variance-covariance matrix are central for the identification method, the
choice of these regimes are somewhat arbitrary. Furthermore, the identifi-
cation depends crucially on the assumptions that monetary policy shocks
are homoskedastic across dierent variance regimes (in absence of this as-
sumption the system remains unidentified). In our view, such assumption
is especially restrictive given the richness of monetary policy setting and its
evolvement through time.
In order to capture more accurately the dynamic interaction between
interest rates and stock returns, the authors augment their VAR with un-
observed heteroskedastic shocks that allow for contemporaneous correlation
between monetary policy and stock market shocks. The generalized spec-
ification with unobserved shocks, while important in measuring the policy
reaction, may contribute to the size of the estimated parameter of central
bank response to stock market. For some parameter values, we find that the
this coecient is a positive function of the variance of unobserved shocks,
biasing upwards the response of monetary policy to stock market.
In a related independent work, Faust et al (2002a) achieve identification
by expoliting additional informations from the federal funds rate futures
market. The method measures the impulse response of the federal funds rate
to the policy shock using federal funds future data and identifies structural
VAR model by imposing that the impulse response of the funds rate to the
policy shock in the VAR matches the one measured from futures data. In
a successive work (Faust et. al (2002)), the authors apply this method to
identify contemporaneous relations between interest rates, monetary policy
rates and exchange rates. Identification is again achieved by requiring that
the impulse responses of the exchange rate and interest rates in a standard
open-economy VAR match the responses estimated from the high frequency
financial market data.
In what follows we propose a new method to identify monetary policy
reaction to stock market that is closely related to the work by Faust et
al.(2002a, 2002b). In contrast to their paper and similarly to Rigobon and
Sack(2001), our method is destined to address the endogeneity issue between
stock market and policy variables. To this end, we depart from existing
literature of exclusion restrictions and allow for contemporaneous response
of monetary policy to asset prices. Since our identification method depends
on measures of policy shocks through changes in futures of fed funds rate,
below we provide a brief review of the literature pioneering this measure.

6
2.2 Changes in Futures of Federal Funds Rate as a
measure of monetary policy surprises
Kuttner (2001) initiated the use of changes in futures of federal funds on
the days of FOMC meetings as a proxy for monetary policy shocks. The
federal funds rate futures contract is based on a monthly average of the
relevant months eective funds rate. Since federal funds futures embody
market expectations on Fed policy actions for that month, any change in the
settlement price of the spot-month future contract on the days of FOMC
announcement constitutes a surprise in monetary policy actions as perceived
by market participants.
As pointed out in Kuttner (2001), building the monetary policy shock
through changes in futures prices can be complicated by at least two factors.
One is that the Fed funds future contract is based on an average of the fed
funds rate rather than the rate on any specific day. The second complication
arises from the fact that the futures contract is based on the eective fed
funds rate rather than the target rate. Both of these caveats are addressed
in Kuttner (2001) where 1) the contract on the average funds rate is unwound
through the use of appropriate weights depending on the day of the month
in which FOMC meeting takes place, and 2) the dierence between target
rate and eective rate on monthly averages is usually very small - within
few basis points.
The advantage of using futures data to measure policy shocks rests with
the ability to circumvent model selection and generated regressor problems
(Kuttner 2001). At the same time, changes in spot-moth fed funds futures
deliver an almost pure market-based measure of the policy surprise. On the
downside, the novelty of fed funds futures market limits any analysis using
future contract to the post 1989 period (future contracts on fed funds rate
were introduced in January 1989).
In this context, fed funds futures are used as proxies for market expec-
tations about Fed policy actions. This is true only if the expectations hy-
pothesis holds and funds rate forecasts based on futures price are ecient.
Kuttner and Krueger (1996), find conclusive evidence that funds rate forecast
errors are not significantly correlated with other variables or any information
available to market participants at the time when the contract is priced. In
a related work, Faust et al. (2002) further corroborate these results.
Recent papers in the discipline have adopted similar measures for exoge-
nous monetary policy shocks through the use of futures data. Faust et. al.

7
(2002), use changes in current month fed funds futures contracts to gauge
monetary policy shocks and achieve identification in a structural VAR model
by matching the impulse response of the funds rate to a policy shock in a
VAR to the response measured with futures market data. To avoid sample
limitations, Piazzezi and Cochrane (2002), employ changes in 1 month Eu-
rodollar rate in a time frame from just before to just after an FOMC meeting
as a measure for exogenous policy shocks.

3 Identification through Proxy and IV vari-

ables
The above discussion indicates that, in a structural VAR context, attempts
to separate responses of monetary policy to stock market from endogenous
reaction of stock market to federal funds rate have contended with renewed
challenges regarding identification method. In this section, we propose a new
way of dealing with this problem that uses proxy and instrumental variables
to identify the system. In what follows we draw extensively from the growing
literature in the area and our identification assumptions rely on previous
works related to our own.

3.1 Identification through proxy variables

Suppose the economy is described by a structural form equation:

A(L)yt = t (1)

where A(L) is a matrix polynomial in lag operator L, yt is (n x 1) vector

of macroeconomic variables, and t is a n x 1) vector of structural errors
such that Var(t ) = D . D is a diagonal matrix assuming that t are mutually
orthogonal. The structural shocks are the primitive exogenous disturbances
in the economy. In what follows, we restrict our attention in the dynamic
structural equations for the stock market and federal funds rate:

F F Rt = SRt + (L)Xt + Ft F R (2)

SRt = F F Rt + (L)Xt + SR
t (3)

8
 where Xt consist of lagged values of macrovariables, federal funds rate
and stock returns. We can rewrite the system as follows:
!
1 F F Rt F F R
= B(L)Xt + t SR (4)
1 SRt t

A0 Xt = B(L)Xt + t (5)
where A0 matrix is comprised of all contemporaneous parameters. The
system can be estimated in its reduced form:

Xt = B(L)A1 1
0 Xt + A0 t = G(L)X + ut (6)
where:

ut = A1
0 t G(L) = B(L)A1
0 and E(ut u0t ) = = (A1 1 0
0 )D(A0 ) (7)

The MA() representation of the model can be written as follows:

X
X
Xt = i uti = i A1
0 ti (8)
i=0 i=0

s-periods ahead this representation becomes:

X
Xt+s = i+s A1
0 ti+s (9)
i=0

The expected value of Xt s periods from now conditional on information

at time t, Et Xt+s , (i.e. the impulse response of variables in the system to
structural shocks) can be written as:

X
Et Xt+s = i+s A1
0 ti (10)
i=0

where s denotes the matrix of MA coecients of the reduced form model.

Specifically, the expected value of stock market s periods from now due
to a shock in monetary policy at time t, (i.e. the impulse response of stock
market to a monetary policy shock) can be written:

X
Et SRt+s = s Fti
FR
(11)
i=0

9
 or alternatively:
Et SRt+s
= s (12)
Ft F R
where is the contemporaneous response of stock market to a policy
shock and s is the appropriate element of i+s matrix identifying the re-
sponse of stock market to a reduced form policy shock s periods in the future.
Since all past shocks (Ft1
FR FFR FFR
, t2 , t3 ...) are known at time t, the change
in the expected value of SRt+s is due only to monetary policy shock at time
t. As such, we can eliminate all past lags and write:

s Et SRt+s = s Ft F R (13)
The above equation captures the change in expectation in stock returns
at time t + s due to an exogenous monetary policy shock at time t. In other
words, this equation identifies the impulse response of stock market at time
horizon s to a monetary shock today (at time t).
Equation (13) can be estimated if we can find a proper measure for the
following two unknowns: 1) a measure that captures changes in expectations
in stock returns due to monetary policy shocks; 2) a measure that properly
accounts for monetary policy shocks. We use changes in future prices of
SP500 contracts in the days of FOMC meetings to measure the reaction of
stock market to an exogenous monetary policy shock. Similar to the case of
federal funds futures, SP500 future contracts at time t embed expectations
of market participants about stock market performance at maturity t + s
based on all available information at time t. (Et SRt+s = SP 500ft ut ). On the
days of FOMC meetings, assuming no other major pertinent information is
released, price changes in SP500 futures will capture the reaction of stock
market participants to a monetary policy shock. Since future contracts are
specified for a time horizon s, the change in its price on the day of the policy
announcement delivers a measure of the stock market reaction at horizon
t + s to a monetary policy shock at time t (it is the stock market impulse
response at time t + s to a policy shock at time t).
Following recent work in the literature, we use changes in futures in federal
funds rate on the days of FOMC meetings as measure of monetary policy
surprises (see Kuttner (2001), Faust et al. (2002), Cochrane and Piazzesi
(2002)). Since the Fed funds future prices are a natural market based proxy
for expectations on future monetary policy, any change in the price of the

10
contract on the day of FOMC meetings should capture unexpected monetary
policy actions - in other words it is a pure measure of an exogenous monetary
policy shock. As pointed out in Faust et al.(2002), there are reasons for
which this assumption may not hold: 1) the FOMC could be reacting to
macroeconomic data released on that same day and 2) the FOMC policy
action itself may reveal information about macroeconomic data that is private
information to the Fed. We address these issues in more detail in Section IV.
Based on above discussion, we can rewrite and estimate equation (13) as
follows:

s SP 500ft+s
ut
= c + s F F Rtf ut + t (14)
where

s = s (15)
Based on our model above, the reduced form variance-covariance matrix
can be written as:
!
X 1 2 2SR + 2F F R 2SR + 2F F R
=( )2 (16)
1 2SR + 2F F R 2SR + 2 2F F R
The variance-covariance matrix of reduced form shocks provides three
equations - while there are four parameters to identify , , 2SR , 2F F R .
With our method, the additional relationship (14) provides the fourth equa-
tion, completing identification of all unknowns and allowing for contempora-
neous responses between monetary policy variable and stock market returns.
Our method hinges primarily on identifying good proxy variables in
estimating equation (13). Changes of fed funds future price on the days
of FOMC announcement are used as proxy for exogenous monetary policy
shocks, while changes in future price of SP500 on policy announcement day,
are used as proxy for stock market reaction to this policy shock. In both cases
we rely on several important assumptions that rationalize the use of these
proxy variables in our identification method. In what follows, we provide a
detailed account of these assumptions and oer supporting evidence for their
validity.

11
3.2 Extension of the Methodology: IV Procedure
As mentioned in the introduction, the above identification scheme depends
critically on the existence of futures contract on financial instruments9 for
achieving identification. In cases when the market for futures contract is not
properly developed or when it is altogether nonexistent, the identification
method proposed above could not be applied. This would restrict the as-
sessment of simultaneous responses between monetary policy and financial
markets only to few financial assets.
To address this issue, we extend the above method to a more general set-
ting adopting an instrumental variable approach. The quest for constructing
instrumental variables to address the endogeneity problem has been exten-
sively addressed in the literature (see for example Bernanke and Gertler
(2000), Rigobon and Sack (2001)). For the majority of cases in these re-
lated works, stock market is allowed to instrument for itself through its own
lagged values. As pointed out by Rigobon and Sack (2001), the search for
an instrument in this context is a trying task since it is hard to conceive
of any variable that would aect the stock market without aecting the path
of interest rates.
While this argument remains undoubtedly true and no existing variable
can independently determine stock returns without being aected from policy
rate changes, below we attempt to instead construct (since it does not already
exist) such an instrument. As in the previous section we focus our attention
on the last two equations of our system which denote the policy reaction
function and the stock return function:

F F Rt = SRt + (L)Xt + ft f r (17)

SRt = F F Rt + (L)Xt + sr
t (18)
A proper instrumental variable must address the endogeneity problem
presented in the system above by eliminating the correlation between stock
returns (SRt ) and monetary policy surprises (ft f r ). Following our previous
approach, we continue to measure monetary policy shocks by changes in fed
funds futures prices on the days of monetary policy announcements. Based
on this intuition, we construct our instrument by regressing stock returns
on monetary policy surprises and use the residuals from this regression as
9
Here we refer to futures contracts on bonds, single securities, and stock indices.

12
instrument for stock variable in the policy function. Specifically, we estimate
the following regression on days of policy announcements:

SRt = o + 1 F F Rf ut + eIV
t (19)
As constructed, residuals from this regression ed
IV = SR SR
t
d = SR
t t
(co + c1 F F Rf ut ) are the share of SRt which is uncorrelated with ft f r ,
because they contains all the information that is embodied in the stock mar-
ket and is not explained by the monetary policy shock. These residuals are
highly correlated with stock returns and by construction uncorrelated with
monetary policy surprises, two desirable attributes for a good instrumental
variable. This method, partialling out the eect F F Rf ut on SRt , allow us
to obtain an IV that purges the stock returns from ft f r , thereby eliminat-
ing the endogeneity problem.
It is important to note that equations (19) and (14) are essentially equiv-
alent. In both cases, we regress changes in stock prices on monetary policy
shocks. The only dierence between the two rests with the fact that es-
timates of s from equation (14) identify the response of stock market to
a policy shock s periods in the future, while estimates of 1 captures the
contemporaneous response. As can be seen, equation (19) requires the use
of actual S&P500 index and not futures prices thereby allowing for a more
general use of the procedure.
Abstaining from the use of futures contracts is one of the advantages
associated with this method. There is a second advantage to implementing
the IV procedure: used in conjunction with the original method, it provides
additional relations among variables in the system that could be exploited
in order to relax other restrictions in the structural VAR. More specifically,
rewriting equation (15):
s
=
s

As indicated by above relation, using the first method to identify entails

estimation of cs from equation (14) and c from a reduced form VAR. Various
s
specifications of VARs would produce a dierent value of c rendering the
s
latter model-specific. However, a joint implementation of two methods would
allow an independent identification of s , providing an additional relationship
between variables in the system. The combined use of both methods adds
the following relations:

13
 1 =

s = s

Both equations could be used to relax further identifying assumptions in

the VAR. In addition to estimating the contemporaneous response between
stock market and policy variables, we could, for example, estimate the con-
temporaneous response of industrial production or inflation, or any other
macroeconomic variable to a monetary policy shock.

4 Identifying assumptions.
Our approach to identification relies on the following three assumptions.
1) Changes in price of spot-month federal funds futures contract on
FOMC announcement days deliver a proper measure of the exogenous mon-
etary policy shock.
2) Changes in prices of S&P500 futures contract on the days of monetary
policy announcement appropriately identify the response of stock market to
a monetary policy shock.
3) VAR is an adequate representation of the economy. This means that
the information that the market participants use to form expectations about
monetary policy actions and stock market performance is coincident with the
information set included in the VAR.
Due to its generality and common usage, we start with the last assumption
which can be written as follows:

Et (F F Rt+1 ) = F utF F Rt = Et (SRt+1 ) + (L)Xt+1 (20)

Et (SRt+1 ) = F utSRt = Et (F F Rt+1 ) + (L)Xt+1 (21)

This assumption is implicitly made in the vast majority of related empir-
ical works, where it is normally assumed that the central bank, the econo-
metrician and the market participants have the same information set. Our
results rely on this assumption the same way as earlier work does. In the
identification context of our paper, however, this assumption assumes more

14
relevancy since it implies that forecasts obtained by the futures market should
be similar to the forecasts generated from VAR. Rudebush (1998) pointed it
out that the two forecasts in eect have little correlation. In contrast, Kut-
tner and Evans (1998) argue that sampling uncertainty associated with VAR
coecients increases the variance of VAR forecasts thereby reducing the cor-
relation between futures market and VAR forecasts10 . Also, quantitatively
small deviations from perfect futures market eciency further contributes
to the perceived reduction of this correlation. In their work, the authors
point out that the informational advantage of the VAR forecasts, VARs
too generous parametrization and parameter stability can additionally lead
to the low correlation between monetary policy shocks measured from VAR
models and shocks identified from futures market.
In a related work, Robertson and Tallman (2001) argue that the corre-
lation between two sets of forecasts can be greatly improved if the VAR is
estimated with Bayesian shrinkage methods that are commonly used to im-
prove the forecasting performance of a highly parametrized VAR. Following
this argument, Faust et al. (2002), reestimate their structural VAR system
with Bayesian estimates and report that their substantive results remain
largely unchanged by this modification.
Further attempts to reduce the information gap between market partic-
ipants and econometrician are reported in Brunner (2001), where a VAR
augmented with market participants expectations of economic variables is
used to mitigate this problem. The author concludes that the innovations,
monetary policy shocks and the impulse response functions derived using this
alternative approach were fairly similar to the standard VAR.
For our first identifying assumption we refer to the work by Kuttner and
Krueger (1996) and Faust et al. (2002). Kuttner and Krueger demonstrate
that funds rate forecasts based on the futures prices are ecient in that
the forecast errors obtained are not significantly correlated with any variables
known at the time when the contract is priced. Faust et al. (2002) test
the eciency of the federal funds rate futures markets by regressing the
eective federal funds rate for month t on the federal funds futures price in
months t 1, t 2, t 3, t 4, t 5. Results indicate that the expectations
hypothesis holds and that the fed funds futures markets provides ecient
forecasts of the fed funds rate. If the price of fed funds futures are ecient
10
This can be easly seen through the following formula Cov(Fd F Rvar , Fd
F Rf ut ) =
d d d d
V ar(F F Rvar + F F Rf ut ) V ar(F F Rvar ) V ar(F F Rf ut )

15
forecasts of the federal funds rate, then they embody all the relevant present
and future information available to market participants about policy actions.
Therefore, a change in the price of fed funds futures on the days of monetary
policy announcement delivers a nearly pure measure of policy shock since it
represents a sudden change in the market participants expectations due to
the arrival of new information.
Another reason that may contribute to the potential failure of the first
assumption is the possibility that other important information could be re-
leased in the market in the same day with monetary policy announcement..
If this is the case, market participants may react to this new information
and changes in prices of futures contracts fail to deliver a pure measure
of the policy shock. In addition, this assumption may also fail if the pol-
icy announcement reveals to the market participants information about the
macroeconomy that is private to the Fed, in which case movements in prices
on futures contracts may be due to the reaction of market participants to
this new piece of information. In addressing both of these diculties we
rely, once again, on the work by Faust et al. (2002), where detailed expla-
nations and tests are provided in support of the assumption. Specifically,
the authors check for other major macroeconomic releases in the days of
policy announcements and conclude that during the entire sample (which
coincides with ours), there are few macroeconomic releases on the days of
FOMC meetings. We perform the same test checking for common macroeco-
nomic releases on the days of monetary policy announcements and find that
for all the variables included in the VAR, industrial production and NAPM
coincide with FOMC meeting and inter-meeting days only four times, PPI
and CPI 5 times and 7 times respectively and nonfarm payroll ten times. On
three occasions, more than one variable were released on the same day with
policy announcement slightly reducing the number of problematic days.
To address the problem that policy announcements may reveal informa-
tion on macro variables, Faust et al. (2002) perform a test regressing market
participants surprise about macroeconomic announcements on the target
rate surprise. The intuition behind this test, as explained in their paper,
is that if the fed funds surprise eectively releases any information about
macroeconomic data private to the Fed, then the target surprise should be
correlated with macroeconomic surprises. Their test results indicate that the
estimated coecient on the target surprise is not significantly dierent from
zero for any macroeconomic indicator, further lending support to the as-
sumption that on days of policy announcements changes in fed funds futures

16
capture policy shocks.
The above assumption can be further improved with the use of intraday
data on fed funds futures contract on the days of policy announcements. This
exercise ensures a more exact measure of market participants expectations
right before and right after an FOMC meeting. A change in these expecta-
tions captured by a change in price on fed fund futures on a smaller time-
window around policy announcement (i.e. futures price changes 5 minutes
before and 5 minutes after the meeting) would be able to deliver an even
purer measure of policy shock. This is true, since there will be a smaller
likelihood for other information to confound our results.
The second assumption is the most problematic one and requires more
attention. Our test for macroeconomic releases on days of FOMC announce-
ments is also useful in the context of this assumption, since it increases the
probability that changes in expectations of stock market participants are due
only to policy shocks. Additionally, performing a test to compare release days
on dividend news, earnings and profit announcements with policy announce-
ment days, would further strengthen the reliability of this assumption.
The ideal way of supporting the notion that changes in S&P500 futures
prices on days of monetary policy announcements deliver a measure of stock
market reaction to policy shock would be through the analysis of intraday
data on stock futures prices. Similar to the above case, futures price changes
right before and right after the meeting would better capture the response of
stock market to a policy shock. In that case, the computations are based on
a narrower time-window allowing for a small possibility that stock market is
reacting contemporaneously to any other piece of information. In this paper
we employ a new dataset consisting of intraday S&P500 future price data in
order to narrow the time frame around a policy announcement as accurately
as possible. Specific details about new dataset, its use and applications are
described in Section 6.
Despite the use of a smaller window of estimation and similar to the
first assumption, the response of stock market to monetary policy shock
(measured by changes in S&P500 futures prices on the days of FOMC an-
nouncements) could be muddled by the reaction of market participants to
any additional information about the state of the economy that policy shocks
may reveal. To address this issue, we again invoke the results reported by
Faust et al. (2002). which demonstrate that correlations between macro
announcement surprises and target rate surprises are not significantly dif-
ferent from zero. Their test is based on forming a measure of the surprise

17
component on macroeconomic announcement based on survey measures of
expectations on market participants. Since their survey data is market-based,
it reflects expectations from a broad range of market participants, including
those that trade in the futures market. Based on their findings, we believe
that changes in S&P500 futures prices on days of FOMC announcement trace
the response of stock market to a policy shock rather than its reaction to
releases of macro data.

5 Data and Variable Description

5.1 Description of the S&P500 future data
In order to achieve identification, we employ a new dataset consisting of in-
traday, real-time future price quotations spanning the period from January
1994 - December 2001. We restrict our attention to this period, since prior
to 1994 there was no exact time for policy releases: the announcements were
irregular on the FOMC meeting days. From 1994 however, the Fed changed
its announcement practices and decided to release changes regarding mone-
tary policy at a precise time: 2:15 PM Eastern time on the announcement
day11 . The raw data were obtained from Chicago Mercantile Exchange and it
consists of continuously-recorded S&P500 future price tick-data with the fol-
lowing information: a ticker symbol, the delivery date followed by a contract
month code, the time of the transaction, the price, an ask/bid indicator, and
the trade date. For one tick observation to be recorded, it is necessary for at
least one transaction of one contract to establish a new tick with a dierent
value from the existing one.
The contract months are as follows: March, June, September and Decem-
ber and they trade for one year in such a manner that at any point in time
there are four contracts available for purchase. The final price settlement
day is the third Friday of the specified contract month. As expected, the
shortest two maturity contracts are the most heavily traded and as such, the
most liquid. They register tick data (or price quotations) with an average
11
Exceptions to this new practice were as follows: 11:05 am Eastern time on 02/04/94,
2:20 pm on 03/22/94 and 07/06/94, 2:30 pm on 11/15/94, 2:26 pm on 05/17/94, 2:23 pm
on 12/20/94, 1:17 pm on 08/16/94, 2;22 pm on 09/27/94, 2:24 pm on 02/01/95 and 3:15
pm on 10/15/98 after the futures market in Chicago had closed so we had to consider the
opening price on the 16th.

18
frequency of one trade every 30 seconds12 . This richness in observations al-
lows us to narrow the time-frame around monetary policy announcement in
a very precise fashion.
The time window is constructed by computing percent changes in aver-
age price data 5 minutes before and 5 minutes after the monetary policy
announcement time (usually 2:15 Eastern time - exceptions to this rule as
explained in footnote 7 are duly noted). Since the time frame before and
after policy release is small, it is reasonable to assume that any price change
occurring within this window results primarily from changes in market ex-
pectations due to monetary policy announcement. The decision to use a five
minute window is quite arbitrary; its sole purpose was to narrow the time
frame around announcement moment as accurately as possible. To ensure
that our results are not aected by this arbitrary choice of time-window, we
redefine and document results for the other time-frames. We compute win-
dows of: 1 minute, 2 minute, 3 minute, 4 minute, and 10 minute. Table 1
summarizes some of the properties of each constructed window.

Summary Statistics for the window data

Variable mean std. deviation min max
1minute window .10542 2.742 -7.377 11.611
2minute winow .5061 3.926 -6.689 17.99
3minute window .594 5.063 -7.687 27.81
4minute window .593 6.229 -9.11 37.73
5 minute window .7043 8.221 -12.29 55.23
10 minute window .3164 9.495 -18.46 59.118
Table1
It is important to note that future price changes due to monetary policy
announcements reflect reaction of stock market participants to a monetary
policy shock not for the current period, but for the day when the contract
matures. Since policy announcement days are spaced irregularly during the
year, each price change observation derived from same maturity contracts
captures the response of stock market to a policy shock at dierent points in
time. The exact horizon is determined by the distance in days between policy
announcement and the day of maturity of the futures contract. Specified as
12
The shortest maturity contract trades very heavily with an observation registered on
average every 8 seconds. The next contract, while still liquid, registers a trade on average
every 50 seconds. The frequency of trades declines with the maturity of the contract.

19
such, a simple regression of the window data on the monetary policy shock as
represented by equation (14) would have little meaning. If each price change
observation (SP 500ft ut in equation 14) registers the reaction of the stock
market to a policy shock at a dierent time horizon, then the estimates we
obtain from (14) would not have a precise temporal connotation.
We address this complication by attempting to construct a window con-
sisting of price changes that reflect same-time horizon expectations. Since a
variety of contracts with dierent maturity date are available at any point
in time, this can be done by selecting those contracts that deliver approxi-
mately same period expectations. For example: if the FOMC meeting is in
March, using the June contract we would be able to capture the reaction of
stock market to monetary policy 3 months ahead. Similarly, if the meeting
occurs in June, price changes of the September contract register reaction of
stock market to a policy shock 3 months in the future. Through this se-
lective process, we can construct a time window consisting of expectational
changes that correspond to a specific horizon: three months in the future.
We generate the window data by using, depending on the day of FOMC
announcement, either the shortest maturity contract or the next one after
that, since only these two contracts deliver expectational changes for three
month ahead horizons. Clearly, we could likewise employ longer maturity
contracts to construct reactions of stock market to a policy shock for longer
horizons. While this is still possible, we employ the shortest two maturity
contracts since they are considerably more liquid relative to the other con-
tracts. This improves our analysis in two levels: 1) the time-window is better
defined around the time of FOMC announcement due to the high number
of observations (trades) occurring each minute; 2) small number of trades in
the long maturity contracts may introduce noise in our analysis by providing
little information about the reaction of stock market to policy actions.
With the new window data constructed as explained, the estimates of
equation (14) have a precise meaning: they identify the reaction of stock
market to a monetary policy shock three months in the future. Rewriting
our model:
SP 500ft+s
ut
= c + s F F Rtf ut + t

SP 500ft+s
ut
= c + s F F Rf utt + t
where the index s underlines the dependence of the dependent variable
and of the coecient on the time horizon. As explained in section 3.1

20
is the appropriate element in the matrix of MA coecients () that comes
from the reduced form model, representing the response of stock market to
a reduced form monetary policy shock. In the present case s = 3, since
by construction b delivers the response of stock market to a policy shock
three months from now. The contemporaneous response of stock market to
a policy disturbance is given by:
b
b =

3

5.2 Fed Funds Futures and Macro Data

In the spirit of traditional empirical literature on monetary policy, we es-
timate a seven variable VAR for the United States augmented with stock
returns. Our specification includes several benchmark variables: industrial
production (IP), consumer price index (CPI), the smoothed change in an
index of sensitive commodity prices (PCOM), a survey index based on the
National Association of Purchasing Managers (NAPM), a measure of mone-
tary aggregate (M2), the federal funds rate (FFR) and S&P500 stock return
(SR). Datastream and Bloomberg are the underlying source for all data se-
ries.
Industrial production, and inflation rate are common variables in mon-
etary business cycle work. Because traditional monetary policy literature
assumes that central banks reaction function systematically responds to out-
put and inflation variables and their indicators, inclusion of these variables in
the system allows for a more accurate identification of central banks policy
reactions. We use industrial production instead of the traditional GDP data
since the latter series is available quarterly whereas industrial production is
reported monthly. The inclusion of NAPM is used to gauge market-based
valuation about the performance of the economy.
All variables with the exception of interest rates and stock market are
expressed in logarithmic form. In our specification we include contempora-
neous and seven non-consecutive lags of each variable, and an FFR shock
corresponds to a measure of monetary policy shock. We use a bloc-recursive
identification methodology for macroeconomic variables and follow the pro-
posed technique presented in this paper to complete identification in the FFR
and SR equations.

21
 We use daily changes (close-to-close) in spot-month federal funds futures
prices to measure of a monetary policy shock, on the days of policy an-
nouncements (including FOMC meetings and intermeeting days). Our sam-
ple includes a total of 69 monetary policy announcements, 5 of which are
intermeeting rate changes and 64 are FOMC meeting releases. Similar to
Faust et al. (2002) and in contrast to Kuttner (2001), our sample includes
those days for which the policy announcement decides to leave the federal
funds rate unchanged.
The federal funds futures contracts settlement price is based on the aver-
age of the relevant months eective overnight Fed funds rate. As mentioned
above, we apply the procedure proposed by Kuttner to undo this average and
measure the policy shock as follows:
m
F F Rt = (F F Rft ut F F Rft1
ut
) (22)
mt
where m is the number of days in the month, t is the day of the monetary
policy announcement and F F Rtf ut (F F Rt1 f ut
) is the future rate of the day t
(t 1) in the contract based on the current months funds rate. Weighting
the daily change in futures prices by this method, corrects the problem by
unwinding the average rate and delivering a purer measure of surprise. This
adjustment factor is quite large if a policy announcement takes place towards
the end of the month, in which case, similar to Kuttner (2001), we use
dierences in one-month futures rates instead of the spot-month contracts.
We employ a similar adjustment in cases when policy announcements occur
in the first day of the month since expectations about policy actions would
have been reflected in the previous months one-month futures contracts.13
Our identification methodology requires the use of price changes in S&P500
futures on days of FOMC announcement to measure the reaction of stock re-
turns to a policy shock. As mentioned in the above section, this response is
computed as percent changes in S&P500 futures prices resulting from the 5
minute window around the time of the policy announcement.
The VAR estimates are carried out in monthly frequency. To confirm the
robustness of our results, we reestimate our model over several time periods:
January 1959-December 2001, January 1979-2001, January 1982-December
13
This method is same as Kuttner (2001) who suggested that in cases when policy
announcement occur in the first day of the month, the dierences between spot-month rate
and the 1-month futures rate from last day of the previous month are a more appropriate
measure of the shock.

22
2001 and January 1994-December 2001.We reestimate the model from 1982 in
the spirit of identifying important changes in monetary policy (the post-1979
era known as the Volcker-Greenspan period) and assessing the importance
of these changes in the reaction of monetary policy to stock market. The
definition of the third subsample (January 1994-December 2001), is due to
the restricted dataset on intraday S&P500 futures. The window data (as de-
scribed in the above section) can be constructed only for the last subsample
since only from 1994 we can identify a precise moment for monetary policy
announcements. Under stability conditions, we can use the same data win-
dow to identify the reaction of stock market to a monetary policy shock for
the other longer samples.

6 Estimation Results
We begin by estimating the reduced form of a monthly seven variables, seven
lags VAR to obtain the appropriate moving average coecients (3 ) in or-
der to identify the contemporaneous response of stock market to a policy
b = b
shock:
c . We then report the response of stock market to a monetary
3
policy shock as indicated by equation (14), estimated on the days of policy
announcements from January 1994-Dec 2001. A contractionary monetary
policy (represented by positive policy shocks and as such increases in fed
funds rate), should have a contemporaneous negative impact in stock prices.
Table 2 summarizes our estimates of (response of stock market to a policy
disturbance) for the 1994-2001 sample. As a robustness check, we report
estimated coecients for all the windows constructed (1 minute, 2 minute, 3
minute, 4 minute,5 minute and 10 minute windows).

Response of Stock Market to a Monetary Policy Shock

23
 dependent Constant Estimated Response to Shock () R2 adj
variable (t-stat) (t-stat)
1minute window -.046 -.042 0.0779
(-0.024) (-2.59)
2minute window .107 -.066 0.0943
(0.44) (-2.84)
3minute window .075 -.099 0.1313
(0.246) (-3.35)
4minute window .010 -.126 0.1414
(0.028) (-3.493)
5minute window -.011 -.16 0.1292
(-0.024) (-3.330)
10minute window -.25 -.176 0.1162
(-0.438) (-3.15)
Table 2
As expected, for all event windows the contemporaneous response of stock
market to a policy shock is negative and significant. This result is very im-
portant: it implies that identification schemes which assume no contempo-
raneous reaction of stock market to a policy shock are inappropriate. A
contractionary monetary policy has a consistent negative contemporaneous
eect in the stock market. As Table 2 indicates, the estimated response coef-
ficient increases with the size of the window: the largest response is recorded
for the 10 minute window and the smallest one for the 1 minute window. For
further analysis, we focus our attention on coecients estimated over a five
minute window, since this time-frame is wide enough to allow for adjustment
in responses of stock market to a policy disturbance, and narrow enough to
center attention around policy announcement time.
For the 1994-2001 sample, the response of stock market to policy shock on
a monthly basis is 0.16, significant at 1% level. Under stability assumption,
we report estimates of for the longer samples: 1959-2001, 1979-2001, 1982-
2001. Table 3 summarizes these results. The estimates for all samples are
negative and significant. The magnitude of the response decreases in the
most recent samples, indicating that stock market participants, being better
informed about policy actions in the later years, register less surprise with
respect a policy change than before.

24
 Response of Stock Market to a Monetary Policy Shock
Sample Constant(t-stat) Estimated Response to Shock ()(t stat)
Jan.1959-Dec.2001 -0.071 -0.969
(-0.024) (-3.330)
Apr.1979-Dec.2001 -0.189 -2.57
(-0.024) (-3.330)
Jan. 1982-Dec.2001 -0.017 -0.235
(-0.024) (-3.330)
Table 3
Once estimates of b are obtained, the identification of policy response
() to a stock market shock follows from the VAR estimation. Estimates of
VAR for indicate that, over most subsamples, the response of monetary
authority to a stock market disturbance is positive and small, and in all cases
except one statistically not significant.
As mentioned in the literature review there is much recent debate in the
discipline concerning the sign and the magnitude of the monetary policy re-
sponse to a positive financial market innovation. Assuming that increases
in stock prices indicate expansionary business cycle periods with increases
in inflationary expectations, monetary policy should respond by increasing
interest rates thus dampening inflationary pressures. However, if positive
innovations in financial markets are due to improvements in market funda-
mentals (technology shocks, supply shocks), monetary authority should not
respond to these innovations, since they do not signal inflationary or growth
stability concerns. To the extend that monetary authority can sift between
dierent types of financial shocks they should respond to stock market dis-
turbances when appropriate: responding to shocks that reflect increases in
inflation and ignoring those shocks that underlie market fundamentals. Since
the ability of Fed to determine types of disturbances aecting financial mar-
kets is limited at best, most advocates in the literature a passive monetary
policy with respect to financial market innovations.
Our empirical findings, summarized in table 4, reflect the non-responsiveness
of the Fed to these financial shocks.

Response of FFR to a Stock Market shock

25
 Sample Estimated Response to Shock ()(t stat)
Jan.1959-Dec.2001 0.0019
(0.3318)
Apr.1979-Dec.2001 0.0315
(4.016)
Jan. 1982-Dec.2001 0.003
(0.6304)
Table 4
For the 1994-2001 sample, our estimates of are negative and insignificant
(b = 0.0038 and t stat = 0.6066). This is the only case that the
estimated response of monetary policy to a stock market shock is of the
wrong sign. Puzzling as this may be, this findings while in contrast with
Rigobon and Sack (2001) are similar to those reported by Bernanke and
Gertler (2000), obtained by estimating forward looking Taylor rules. For
the 1959-2001 and 1982-2001 sample, our estimates of are positive and
insignificant with magnitudes of b = 0.0019 for the 1959-2001 period and
b = 0.003 for the 1982-2001 period. These results seem to lend support
to the idea that in reality monetary authority has not targeted financial
market directly; the estimates of are very small and in the above samples
not significant. Only the estimated response for the 1979-2001 sample is
significantly positive with a magnitude of = 0.031. However, since 1979-
2001 and 1982-2001 are overlapping for most of the sample, the diering
results between these two periods could be due to the conduct of policy
between 1979-1982 (in this period the Fed targeted non-borrowed reserves as
a policy instrument).

7 Conclusion
This paper attempts to address the endogeneity issue arising in a structural
VAR model between monetary policy and stock market variables. In order
to assess contemporaneous relations between fed funds rate and an aggre-
gate stock market index, we employ a new identification scheme that allows
estimation of simultaneous reactions among these variables, therefore elim-
inating exclusion restrictions commonly employed in the literature. We use
changes in fed funds future data on the days of FOMC announcements to
measure exogenous structural policy shocks, and changes in future prices of

26
S&P500 defined over a small window around announcement time to measure
reaction of stock market participants to a policy innovation. The additional
relationship, resulting from the use of future data to estimate stock market
reaction to a policy disturbance, completes identification and allows for con-
temporaneous responses between monetary policy variable and stock market
return.
Our results indicate that stock market participants react strongly and sig-
nificantly to monetary policy innovations. A contractionary monetary policy
depresses asset prices for the current period. These results are robust ac-
cross various sample specifications, with the most recent sample (1994-2001)
registering the smallest magnitude of response. We believe that diminish-
ing reactions over time are due to the higher degree of transparency and an
improved communication between the Fed and market participants during
recent years. At the same time, increased eorts from the part of private
sector in predicting and monitoring actions of the central bank, have con-
tributed towards the creation of a better informed public. If central banks
actions are correctly anticipated in advance, a diminished response from the
part of stock participants to a policy disturbance should be expected.
Our identification method enables us to assess the other side of the issue:
reaction of federal funds rate to a financial market shock. Although much of
the recent debate in the literature attempts to address the question whether
central banks should systematically respond to asset prices, this paper focuses
in estimating this response. Our empirical results indicate that over most
samples the response of monetary authority to a stock market shock is small
and insignificant. In the 1994-2001 subsample the response is small, negative
and insignificant. Over all other subsamples, the response is positive and
insignificant, with the exception of 1979-2001 period, where the response
coecient is larger than all other samples and statistically significant. This
estimation analysis seems to confirm the fact that in the past the Fed has in
eect acted as it has professed so far: it has not directly targeted asset prices
in the conduct of monetary policy.
The empirical results presented in this paper should be regarded as a
first tentative in estimating the contemporaneous relationships between stock
market and monetary policy under more general conditions and without im-
posing any exclusion restrictions on the parameters of interest. One impor-
tant limitation of the proposed method rests with the restricted availability
of futures data both for federal funds rate and S&P 500. Fed funds futures
contracts were introduced in January 1989. The S&P 500 futures data were

27
introduced in January 1982, however, the irregular announcements of mon-
etary policy prior to 1994 diminishes the practical use of this data in the
present context. As such, analysis for earlier samples can be carried out
only under stability assumption. Despite these caveats, we believe that new
identification methods should be employed to sidestep exclusion restrictions
and address the endogeneity problem between variables with simultaneous
reaction. Although identification issues in cases of endogenous responses
continue to remain a complex task, we believe that further research in the
area will enrich our understanding and oer a better characterization of the
interaction between monetary policy and financial markets.

28
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