Sunday, February 21, 2010

The Fed Effect: Central Banks and Equity Value

Last week, the Federal Reserve announced that it would increase the Fed Funds rate by 0.25%. While the increase was small and the overall rate still remains low, by historical standards, concerns about the implications to the stock market surfaced almost immediately.
http://www.nytimes.com/2010/02/19/business/19fed.html
While, at first sight, this seems like unmitigated bad news - higher interest rates, after all, hurt stock prices - the effects of central bank interest rate policies on equity values is a little more ambiguous. There are several forces that come into play:

a. The Interest rate effect: Did the Fed raise interest rates last week? Not really. First, the only rate that the Fed has direct control over is the Fed Funds rate, i.e., the rate at which banks borrow from the Fed for emergency short term funding, a very small proportion of overall loans. Second, while it is true that the Fed's actions can affect market interest rates, the effect is more at the short end of the term structure than the long end. Thus, an expansionary central bank can push short term rates down but has relatively little influence over long term rates. That is also the reason why yield curves can become downward sloping, when central banks adopt restrictive monetary policies. In both valuation and corporate finance, it is the long term interest rate that determines discount rates and value.

b. The Inflation effect: Monetarists have long argued that the primary job of a central bank is to keep the currency from being debased, by holding inflation in check. Building on that theme, it has also been shown fairly conclusively that the biggest factor driving long term interest rates is expected inflation. Thus, a central bank that raises short term rates may be viewed by markets as fighting inflation, which can cause long term interest rates to fall contemporaneously.

c. The Economic Growth effect: For better or worse, central banks have also been assigned the role of custodians of economic growth. Thus, central bankers have to weigh the inflation fears against the real growth consequences, when raising or lowering rates. Markets therefore view the central bank's final actions as signals of what the central bank thinks about future economic growth. Thus, it is argued that a central bank that raises rates will do so only because it has information that leads it to believe that economic growth is strong enough to withstand the rate increase. Ironically, a rate increase can then be viewed as good news about future economic growth.

So, what do I think will happen to stock prices if central banks raise interest rates? Rather than give you the classic, "It depends ..." response, let me take a stand.
- If the central bank is viewed by markets as informed, independent and credible, a rate increase should be good news for markets; the real growth effect should dominate the effect on short term rates.
- If central banks are viewed as weak and/or uninformed, their actions will have little effects on markets, in the most benign case, and have negative effects, in other cases. As an example of the former, think of Japan in the 1990s, where the central bank was viewed as ineffectual. As an example of the latter, think of almost any Latin American country's central bank in the 1980s.

The bottom line. It is in every economy's best interests to have a central bank that is viewed as strong and effective, since the actions of the bank may be the last, best defense against economic meltdowns. Unfortunately, central banks become easy scapegoats for politicians, when economies stumble. Take the president of Argentina, Christina Kirchner, who recently fired the Argentine central banker (after repeatedly misfiring):
http://online.wsj.com/article/SB10001424052748704533204575047631291330838.html
Count me among those who will not be investing in Argentine companies in the near future. And how about the US? Ben Bernanke, the Fed Chair, was made to jump through hoops by senators, before they voted on renewing his chairmanship. Not surprisingly, they wanted him to promise that he would put employment above inflation in his decision making..... Poltical short sightedness knows no borders.

124 comments:

twilexia said...

Hi Professor,
Thank you for not taking the "it depends" stand! It's very refreshing to hear, because that line frequently translates into "I don't know," or "I don't have a strong enough belief in my own knowledge to take a side."

So you are saying that the increase in federal funds rate will be good for the economy, given the "trustworthiness" of the Federal Reserve. It reminds me of the time period from 2007-early 2008 (before the huge stock market crash of late summer) where the Fed lowered the rate from 5-2%. These decreases may have been in response to Bear Stearn's collapse, but do you think that, (given what you said about the respectability of our Fed) markets may not have fallen as far had the Fed kept a higher funds rate?

Aswath Damodaran said...

I am leaving that judgment call to you. If you believe that the Fed has good information and is independent, it is good news. If you don't (and there are quite a few skeptics there), it is not. In spite of all the criticism that it has received, I think that of all the institutions in the crisis, it has come out the best.

Raghu said...

Dear Professor,

How does the market deal with the possibility that the Central bank is informed and effective, however is gaming the system precisely to send the intended signal and get the desired response? While doing this often might be a give-away, it seems to me that during serious meltdowns the Fed can get away with a "fake it till you make it" attitude on a one-off basis. (I am not a finance student, so pardon me if I am being too simplistic here!)

Aswath Damodaran said...

True, but you have to make a trade off. Each time you game the system, you lose some credibility. Central banks that have built up a reservoir of trust can get away with this type of behavior, but they should reserve it for a true crisis.

twilexia said...

Hi Professor,
Thanks for your answer. The Fed is an easy prey to pick up for activists, but I suppose what is really important is whether the banks respect/trust the fed. In fact, I feel that the bailout may have led to increased bank reliance to the fed; for better or for worse economically, at least such increase compensates for the reputation that the fed lost with the public.

This isn't related to your blog, but I was reading your interview with Tom Gardner. One of your quotes has inspired me deeply, and you probably can guess which one it is ("[Bubbles] reflect what I think is most appealing about the human spirit, which is you keep hoping to do things that are beyond your reach.")

To play devil's advocate, one can argue that bubbles are caused by a variety of factors outside of a pure sense of perseverance (not exactly the right word, I know). It is a very controversial, albeit ethical defense of capital markets, which I'm sure you'll have many detractors (especially activists and politicians). But, as you said, from a purely "human civilization" standpoint, bubbles represent the epitome of unrestrained human greed. The only problem is that the illogical side of our natures will always cause us to overreact to such bubbles, which is a rather harmful downside. What can be done, then, to mitigate such overreaction?

Fabian said...

Dear Professor

Very intersting comment about central bank (your thoughts are true for all central banks). I would like add:

- the markets should not only trust the central bankers, but also governments. Lack of independence - like in Argentina - is no good sign.

- how can we trust the central banks, if well kown economists like Bill Gross claim, that we do not have theories which help us analyse the effects of quant tightening?

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Saurav Roychoudhury said...

What Fed really did was to raise the discount rate to 0.75% from 0.50%. It is an harbinger of things to come but the Fed funds rate is still in the 0-0.25% range. The increase in discount rate always has a much muted effect than the increase in fed funds rate.

123 - themoneydemand.blogspot.com said...

Dear Aswath,
your post has a slight error, as Fed has changed the discount rate, not the Fed funds rate.

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