Assessing the Impact of Federal Reserve Policies on Equity Market Valuations: An Instrumental Variables Approach

Round 1

Reviewer 1 Report

Comments and Suggestions for Authors

Review report for “ASSESSING THE IMPACT OF FEDERAL RESERVE POLICIES ON EQUITY MARKET VALUATIONS: AN INSTRUMENTAL VARIABLES APPROACH”

I. General appraisal
The paper examines the influence of central bank interventions on stock market pricing dynamics by employing an instrumental variables three-stage model approach. Specifically, it analyzes the impact of changes in the Federal Reserve's balance sheet size during three key periods: the Great Recession (2008-2013), the Covid-19 pandemic (2020-2021), and a broader timeframe encompassing both events. The results demonstrate a significant correlation between fluctuations in the Fed’s balance sheet and the pricing of major U.S. equity indices, highlighting a time-dependent effect that emphasizes a widening disparity between pricing mechanisms in equity and debt markets. This research offers valuable insights into financial asset pricing, particularly by revealing how interventions in government debt markets can lead to price distortions in specific equity markets.
The paper is well-structured and written, with a thorough exposition of the methodology and findings. I have some minor comments to achieve the publication level of the journal.

II. Specific comments
1. The “Introduction” section while very intriguing and affluent is very long! I recommend to move the parts related to the “Operation twist”, “Covid-19 QE”, “Timeline of Great Recession Fed Policies”, and “Timeline of the Covid-19 crisis” to another independent section.
2. Please rewrite the announcement of the paper structure in a more captivating manner.
3. Figures 1, 2, 3 should be resized in a high resolution as the current content, except the colors, is not totally clear!
4. While the reference section is extensive, the first paragraph of the theoretical background lacks citations to justify the selection of variables (t_yield, Fed_Frate, wti_spot, usd_cpi, usd_eur). Although the authors likely relied on economic reasoning, they should bolster their rationale by citing relevant sources.
5. In p.10, the sentence reads as follows: “H5: Despite the application of similar types of stimuli in different periods of crisis, varying effects are observed.” What does this mean exactly?
6. In p.13, please rewrite the following “Duly, Cochrane (2017), Guerrieri & Lorenzoni (2017), Korinek & Simsek (2016) coincide that liquidity traps are often present when interest rates near the zero lower bound.” Instead of “coincide that”, use “share the fact that” or “conclude that” or “affirm that”, etc.
7. While the empirical modeling is sound, I have concerns about using the expression “long-term effects” used in this sentence, for example, “Consequently, the novelty of our study lies in identifying the structural, long-term effects of such interventions…”. The Instrumental Variable Three Stage Least Squares, the Seemingly Unrelated Regression (not Equation), and the Two-Step Iterated Generalized Method of Moments provide rather instantaneous variables’ effects! Further, not even lagged regressors were employed in the authors’ empirical framework. Please revise throughout the text whenever “long-term” expression shows up!
8. The authors should refine their discussion with a comparison of their results to the existing literature. Which finding aligns with (or veers of) previous research?
9. Limitations of the study should be provided in the “Conclusion” section!

Author Response

Specific comments

1. The “Introduction” section while very intriguing and affluent is very long! I recommend to move the parts related to the “Operation twist”, “Covid-19 QE”, “Timeline of Great Recession Fed Policies”, and “Timeline of the Covid-19 crisis” to another independent section.

Thank you for pointing this out. We agree with this comment. Therefore, we have removed those sections except for the “Covid-19 QE” text, though the subtitle has been eliminated to make the introduction more concrete. We estimate that the removal of such information does not affect the purpose, scope and aims of the study.

2. Please rewrite the announcement of the paper structure in a more captivating manner.

We agree with your comment. We have, accordingly modified the structure outline paragraph in page 7.

3. Figures 1, 2, 3 should be resized in a high resolution as the current content, except the colors, is not totally clear!

Thank you for pointing this out. Therefore, these figures have been pasted in a SVG format for better identification of the data series in pages 4 and 5, respectively.

4. While the reference section is extensive, the first paragraph of the theoretical background lacks citations to justify the selection of variables (t_yield, Fed_Frate, wti_spot, usd_cpi, usd_eur). Although the authors likely relied on economic reasoning, they should bolster their rationale by citing relevant sources.

We agree with your comment. We have, accordingly, modified the structure of the theoretical  background and transferred the variables function to the end of the Literature Review paragraph in page 11. To link this subsection to the literature we only make a short economic theory introduction and have inserted the phrase “and based on the literature discussed above” in page 11, as this theoretical framework results from the literature reviewed, and all we do is to link the variables discussed in pages 7 through 10, with their corresponding citations, into that variables selection function. 

5. In p.10, the sentence reads as follows: “H5: Despite the application of similar types of stimuli in different periods of crisis, varying effects are observed.” What does this mean exactly?

Thank you for pointing this out. We have, accordingly, modified this hypothesis to “H5: Although similar types of monetary interventions were implemented in two different crisis periods, different effects were observed” in page 12. We hope this clarifies sufficiently.

6. In p.13, please rewrite the following “Duly, Cochrane (2017), Guerrieri & Lorenzoni (2017), Korinek & Simsek (2016) coincide that liquidity traps are often present when interest rates near the zero lower bound.” Instead of “coincide that”, use “share the fact that” or “conclude that” or “affirm that”, etc.

We agree with your comment. Therefore, we substituted the words to “share the fact that” in page 9.

7. While the empirical modeling is sound, I have concerns about using the expression “long-term effects” used in this sentence, for example, “Consequently, the novelty of our study lies in identifying the structural, long-term effects of such interventions…”. The Instrumental Variable Three Stage Least Squares, the Seemingly Unrelated Regression (not Equation), and the Two-Step Iterated Generalized Method of Moments provide rather instantaneous variables’ effects! Further, not even lagged regressors were employed in the authors’ empirical framework. Please revise throughout the text whenever “long-term” expression shows up!

We agree with your comment. Therefore, we have clarified in page 6 by inserting “That is, our study identifies the trends rather than the instant effects of the variables involved on the valuation of equity indices in the U.S. market.” and “to estimate trends instead of short-term impulse-response estimations of other methods such as structural vector autoregressions (VAR). Hence, our estimations aim at viewing a step further than short-term valuations.” Moreover, in agreement with your comment, we have also reviewed other parts of the paper where the expression “long-term” shows up and modified the one in page 30 to “long-run effects on the pricing of financial assets are to be considered. Such effects include changes in the trends of key macroeconomic series that hint”  

8. The authors should refine their discussion with a comparison of their results to the existing literature. Which finding aligns with (or veers of) previous research?

We agree with your comment. We have included related literature for debate in this section in page 26 “This fact goes in agreement with what Bernanke (2020) pointed about the effects of the lower bound, in which it would be fair to moderately allow the inflation rate target to increase.” and page 27 “This last fact may contradict Cochrane (2018), though for a short period.”.

9. Limitations of the study should be provided in the “Conclusion” section!

Thank you for pointing this out. Therefore, we have included the limitations of the study in the “Conclusions” section in page 31 where reads “This may be a limitation of our study as the methods used are unable to capture how the liquidity flows circulate among markets.

Another limitation thrives in the fact that this work focuses on identifying the effects on the trends of a particular market such as the U.S., for which integration of other relevant markets (e.g., the European and Asian) would considerable help decompose the effects here identified.”

 

Reviewer 2 Report

Comments and Suggestions for Authors

Abstract

Split the first sentence into 2 parts. Stop at stock markets for the first sentence. This is the purpose of the paper. The next 2 sentences must describe design and methodology. The use of instrumental variables in a three state model provides some, though not all of the content of the design and methodology sentences. Then list findings in 3 sentences. These are results. Finally, add 2 sentences for Conclusions.

Introduction

The introduction has a lengthy lead in to the effect of Fed policies on the financial markets. It is all economic theory until page 5, when the impact on financial markets begins. Shorten the lead into 2 pages, especially the timelines of Operation Twist and Covid stimulus. Pages 5-6 must cite other studies that are related. There are no citations of current literature. What have other studies discovered ? What is the research gap in previous literature that this study seals ?Towards the end of the Introduction the authors describe their study as being novel. Why is it novel ? Provide an explanation.  

Literature Review

Separate the Literature Review and Hypotheses Development into 2 sections. A few studies are mentioned in the Literature Review. That is not enough. Add 4-6 more papers. 

Split the Literature Review into subsections. 

Hypotheses Development

Justify each of the 5 hypotheses. Provide an explanation such as why do you think that that excessive liquidity intervention leads to asset overpricing in Hypothesis 1. Is there literature to support the impact of excessive liquidity on asset overpricing ? If yes, cite it. Describe underlying theories of monetary policy that explain the link between excessive liquidity and overpricing. 

Section 3 and Section 4 are acceptable.

Divide Discussion into 3 parts. Part 1 is the Discussion of Results. Rewrite the hypotheses, and state whether they have been supported in the study. Part 2 is Theoretical Implications in which you relate this study's findings to prior literature. Part 3 is Limitations and Recommendations for Future Research. Provide a short paragraph with 3-4 limitations and 3-4 suggestions for future research that flow from the limitations.  

 

Comments on the Quality of English Language

Moderate editing required. 

Author Response

1. Abstract

Split the first sentence into 2 parts. Stop at stock markets for the first sentence. This is the purpose of the paper. The next 2 sentences must describe design and methodology. The use of instrumental variables in a three state model provides some, though not all of the content of the design and methodology sentences. Then list findings in 3 sentences. These are results. Finally, add 2 sentences for Conclusions.

Thank you for pointing this out. We agree with this comment. Therefore, we have modified the abstract to “This study investigates the impact of central bank interventions on the pricing dynamics of select stock markets. The research utilizes the instrumental variables three-stage least square (3SLS) model approach. It analyses the effects of”  and “Our methodology include estimations of the Seemingly Unrelated Equations Regressions (SURE) and the results are robust under the two-step Generalized Method of Moments (GMM).”

2. Introduction

The introduction has a lengthy lead in to the effect of Fed policies on the financial markets. It is all economic theory until page 5, when the impact on financial markets begins. Shorten the lead into 2 pages, especially the timelines of Operation Twist and Covid stimulus. Pages 5-6 must cite other studies that are related. There are no citations of current literature. What have other studies discovered ? What is the research gap in previous literature that this study seals ?Towards the end of the Introduction the authors describe their study as being novel. Why is it novel ? Provide an explanation.   

We agree with your comment. Therefore, we have removed those sections except for the “Covid-19 QE” text, though the subtitle has been eliminated to make the introduction more concrete. We estimate that the removal of such information does not affect the purpose, scope and aims of the study. We have also modified the last part about the novelty to make it more clear.

We have adjusted the phrase “they must consider the enduring effects” for “the investment public considers the enduring effects” in page 6, and “and the investment public” in page 7, as it best fits the intended objective of our research.

3. Literature Review

Separate the Literature Review and Hypotheses Development into 2 sections. A few studies are mentioned in the Literature Review. That is not enough. Add 4-6 more papers.

We agree with your comment. We have, accordingly, modified the structure of the theoretical  background and transferred the variables function to the end of the Literature Review paragraph in page 11. To link this subsection to the literature we only make a short economic theory introduction and have inserted the phrase “and based on the literature discussed above” in page 11, as this theoretical framework results from the literature reviewed, and all we do is to link the variables discussed in pages 7 through 10, with their corresponding citations, into that variables selection function. 

We have also added some papers:

Peersman et al., 2021,

Chen et al., 2021

Brana & Prat, 2016

4. Hypotheses Development

Justify each of the 5 hypotheses. Provide an explanation such as why do you think that that excessive liquidity intervention leads to asset overpricing in Hypothesis 1. Is there literature to support the impact of excessive liquidity on asset overpricing ? If yes, cite it. Describe underlying theories of monetary policy that explain the link between excessive liquidity and overpricing.

We have given a brief explanation of the hypotheses and cited some of them as pertinent.

About the excess liquidity to overpricing of equity securities, we explain these effects in page 23 to  support H1.

5. Section 3 and Section 4 are acceptable.

Thank you for your positive comments.

6. Discussion

Divide Discussion into 3 parts. Part 1 is the Discussion of Results. Rewrite the hypotheses, and state whether they have been supported in the study. Part 2 is Theoretical Implications in which you relate this study's findings to prior literature. Part 3 is Limitations and Recommendations for Future Research. Provide a short paragraph with 3-4 limitations and 3-4 suggestions for future research that flow from the limitations. 

We added:

“As the results of these tests indicate, the pricing in both the treasury yields and the currency, are highly influenced by the central bank balance sheet, and these affects the pricing of equity securities, in support of H2 and H3.” in page 20.

“These results indicate that the pricing of the equity index should have adjusted matching the effects of the expansion of the central bank balance sheet on the treasury yields and the currency rate, yet the index continued into an overvaluation trend, in support of H1.” in page 22.

“, in support of H5” in page 27.

“, supporting H4” in page 27.

“, once again strongly supporting H5” in page 29.

We have made adjustments to the Implications, and added the Limitations in the conclusions section. Finally, opportunities for future research are also in the conclusions.

 

Round 2

Reviewer 2 Report

Comments and Suggestions for Authors

 Hangers have been made. The paper can be published.

Comments on the Quality of English Language

Moderate editing.

Author Response

Good evening, dear Academic Editors,
We have reviewed for abreviations and symbols in equations. Please let me know whether there are any not corrected ones. About recent citations, the paper has not been published anywhere else. The research was conducted until 2023 for which references from 2023 or more recent are not cited in this work.
Best regards,
Carlos R.