Home Federal Reserve Central Banks Are Propping Up Stock Prices – Thorsten Polleit (04/12/2019)

Central Banks Are Propping Up Stock Prices – Thorsten Polleit (04/12/2019)

Financial markets seem to have a great deal of confidence in the effectiveness of central bank monetary policy — in the sense that by keeping interest rates low, or bring interest rates down, the economies will keep expanding and asset prices, in particular, will keep rising. There is, however, good reason for savers and investors alike to think very carefully about the truth value of such a proposition.

The key question is this: What is the actual relation between the interest rate and asset prices, stock prices in particular? To answer this question, it may be helpful to take a brief look at the well-known “Gordon Growth Model”. It shows the functional relation between a firm’s stock price and its profit level, the interest rate, and the firm’s profit growth rate. The formula is:

stock price = D / (ig),

whereas D = dividend, i = interest rate, and g = profit growth.

If, say, D = 10 US$, i = 5% and g = 0%, the stock price is 200 US$ [10 / (0.05 – 0) = 200]. If g then goes up to 2%, the stock price rises to 333.3 US$. If the central bank lowered the interest rate to 4%, the stock price goes up further to 500.0 US$. Should g then drop to 1%, the stock price would decline back to 333.3, and if g falls even lower to 0,005%, the stock price falls to 285.7.

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This little example shows that a central bank can drive up stock prices by lowering the interest rate. However, what about the effect the interest rate has on firms’ profit growth? From a Keynesian viewpoint one may argue: well, lower interest rates trigger new spending, and this should increase firms’ profits. While that may well be so in the short run, one might expect additional effects emerging in the longer term: namely that a policy of extremely low interest rates could sap the strength out of an economy.

For instance, artificially low interest rates keep unprofitable businesses alive, making it harder for better producers to gain market shares. This, in turn, slows down competitive pressure in factor and products markets, resulting in lower growth and employment, and ultimately deteriorating firms’ profit situation. Also, low credit costs invite governments to ramp up deficit spending, diverting scarce resources into unproductive projects. The material well-being of the people remains below potential.

The above points towards an uncomfortable scenario: Central banks, via their policy of extremely low interest rates, drive up stock prices to ever higher levels. Then, at some point, investors factor in the low rate policy’s counterproductive effect and revise their expectations regarding firms’ future profit growth downwards. Once a stock price decline starts, it would be fairly difficult to bring it to a stop – if and when interest rates have already reached rock bottom.

Needless to say that a decline in stock prices would also most likely be a drag on other goods’ prices – such as, say, raw materials, intermediate goods’ and housing estate prices. A general downward shift of prices would be a heavy burden on today’s unbacked paper money system – first and foremost because declining prices could trigger a massive round of credit default: As their nominal incomes decline, or fall below expectations, borrows will find it increasingly difficult to service their debt.

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In the extreme case, the unbacked paper money system could even come crashing down. For if the credit market, due to default concerns, drives up borrowing costs and makes credit less accessible for borrowers, a bust is very likely. This would actually explode the economy’s production and employment structure that has been set up in the period of artificially lowered interest rates.

Of course, governments and their central banks would want to prevent, by all means, such a price deflation and the ensuing crash. In this effort they can count on the support of the wider public: People simply don’t like recession and unemployment. One option monetary policy-makers might have in mind is pushing interest rates (even further) into negative territory, at least in real terms. However, this might not be as easy as it seems.

For there is something called the “zero bound of nominal interest rates”. It means that nominal interest rates cannot be pushed below zero. So if and when prices fall, interest rates remain positive, or even rise, in real terms. And this would certainly not stop a credit pyramid from coming crashing down. And so central banks will see just one way out: outright money printing – via asset purchases and/or issuing ‘helicopter money’.

But who shall get the newly issued money? Should it go into the hands of consumers, or entrepreneurs, or banks, or the government? Or to all of them? And how much money should be issued? Should it be issued early or later in the month? Should everybody get the same amount or, say, a 10 percent increase of his bank deposits? What is the proper principle for distributing new quantities of money? Welcome to socialism!

The monetary policy of extremely low interest rates is far from harmless — even though it seems to support the business cycle and props up asset markets in the short-run, suggesting that all is well. There is, in fact, sound economic reason to assume that central banks’ artificially low interest rate policy is self-defeating — and the risk that something will go terribly wrong increases, the longer interest rates remain at suppressed levels.

Dr. Thorsten Polleit, Chief Economist of Degussa and macro-economic advisor to the P&R REAL VALUE fund. He is Honorary Professor at the University of Bayreuth.

THIS ARTICLE ORIGINALLY POSTED HERE.