Following the 1929 Wall Street collapse, the initial response to the institutional failures and collapsing financial system was to allow the markets to self-correct, which led to a significant period of economic depression. In contrast the US (and UK) governments responded to the 2008 financial crisis with extra liquidity for the banking sector and a stimulus package, but why was there such a different response? Following a light touch approach to Bear Stearns and Lehmann’s, it became clear that without greater intervention, the effect would become contagious throughout the financial system. One of the most important forms of intervention was Quantitative Easing (QE) and historically low interest rates. This study finds that QE substantially reduced the Equity Risk Premium on S&P equities through a 9.6% rise in prices, thus reducing returns. Consequentially, this drives portfolios to seek risker asset classes to make up for the shortfall in returns. This suggests that the combination of low interest rates and QE, when compared to expansion alone, has had a marked change on equity prices and ERP. Furthermore, there is evidence that regime shifts support these findings. Such unforeseen consequences in the equity markets is of great interest to policy makers when deciding on a response to such exceptional circumstances, and researchers investigating monetary policy responses to the next inevitable extreme financial crisis.
- equity risk premium, regime shifts, quantitative easing, portfolio balance channel, equity returns, US Treasuries.