Business Research

Connecting the Dots Between Monetary Policy and Stock Returns

A journal reviewer's rigor prompted Ted Moorman and his research partner to take multiple leaps at their findings about monetary policy and stock returns so they could explain them with clarity.

Only after several rewrites did the picture become clear enough for the researchers to explain their work to others, says Moorman, an assistant professor of Finance, Insurance and Real Estate. He credits the reviewer's prodding with the logical explanations in the article, "Inter-temporal variation in the illiquidity premium" that appeared in the November 2010 Journal of Financial Economics.

The reviewer's words to Moorman and coauthor Gerry Jensen of Northern Illinois University were: "I want a linear, logical story beginning with monetary policy and ending with stock returns."

That insistence improved the paper, Moorman said. "But it seemed like that was the most difficult part because none of the theories we looked at directly related monetary policy to this illiquidity premium."

Moorman and Jensen found evidence of a systematic link between shifts in monetary conditions and the difficulty or ease in trading a stock, and the extra return an investor might get on a stock that is difficult to trade, and how that changes over time.

The researchers used monetary policy as a measure of the funding available to investors in capital markets because they knew that expansive monetary policy created a surge in funding, and that restrictive monetary policy created restraint. They faced the challenge of couching the theory in language that an empirical reader could understand. But that problem dissipated as they parsed the findings.

Improved liquidity and funding reduce the returns required for holding illiquid securities, Moorman said. "Consequently, illiquid stocks experience relatively large price increases when monetary conditions become expansive, and the measured return spread between illiquid and liquid stocks expands substantially," he said. "Our evidence supports the claim that the price of asset liquidity is dependent on monetary conditions."

Moorman, at Baylor since June 2010, says the research was a way for him to meet the monetary policy interests of his coauthor, a colleague at Northern Illinois University.

"Liquidity was of interest to me-not something I had studied much before-but I thought that these two (monetary policy and liquidity) might be related," he said.

He and Jensen discussed ideas, found studies that supported their interests, and got to work.

"The data presented itself with a story that seemed backed up by theory," Moorman said. "You have to have a clear, robust result and theory that can explain that result, otherwise it can just be a pattern, or just a theory unsupported by the data."

Moorman focused on the data and Jensen took the writing lead because of their individual strengths.

"He took most of the burden of explaining the details of monetary policy data," Moorman said. "He also suggested tests to run. I worked very hard to try to clarify our argument and some of the discussion. We were both involved in every step along the way."

The research was attractive to the publisher for several reasons.

"Some of these theories were pretty new and not completely worn out in their testing," Moorman said. "Showing how some very recent theories could explain phenomenon in markets was attractive." The subject also offers popular appeal with the attention focused on monetary policy, he added.

Moorman's research on liquidity continues. He also focuses his research on topics related to his classroom lectures on investment analysis.

"I like to have my teaching and research as one thing-to have my research motivated from my teaching," he said. "What I get from research, I like to bring that back into my teaching."

Ted Moorman
Baylor University