Guest Contribution: “When Does Monetary Tightening Deflate a Stock-Market Bubble?”

In this guest contribution, Jamel Saadaoui, along with William Ginn and Evangelos Salachas, examine when monetary tightening restrains speculative equity valuations and when it does not. The authors argue that the results of previous studies can be reconciled by considering the inflation environment in which the policy-related surprise occurs.

Using monthly U.S. data from September 1997 to December 2023, the authors find that the inflation environment not only changes the magnitude but also the sign of the response of speculative equity valuations. They identify bubble-like speculative valuation episodes by using the Gao and Martin (2021) dividend-yield valuation component and the cyclically adjusted price-to-earnings ratio associated with Campbell and Shiller.

The authors' findings suggest that tightening can have opposite effects depending on the inflation environment, with a lower policy-error and macroeconomic tail risk compressing required risk compensation and protecting the lower tail of future cash flows.

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