Monday, June 05, 2006

Why Does Bernanke's Small Talk Move Markets?

Consider the Bartiromo Affair: At a media dinner party, Federal Reserve Chairman, Ben Bernanke tells CNBC reporter Maria Bartiromo that Wall Street types underestimate his inflation-fighting credentials and expresses his willingness to continue raising the Fed's interest rate target in order to check inflation. Ms. Bartiromo finds the comments newsworthy, reports the chairman's sentiments on her CNBC program, and sets off a sharp decline in stock prices just before the market closed on Monday, May 1. Keep in mind that stock prices move up and down all of the time for lots of different--often inexplicable--reasons. Ms. Bartiromo's TV show may or may not explain the movements at the end of the day on May 1. Generally, however, changes in interest rates (or expected changes) send stock prices in the opposite direction--that is, interest rates and stock prices are negatively related. Why?

The Fed influences a variety of interest rates in the economy by targeting changes in the federal funds rate. Interest rates have a direct effect on stock values, because investors have required returns they demand for holding financial assets, like stocks. Suppose an investor thinks she can earn a 5% return on her money by purchasing financial assets. Holding risk aside, she will only buy a stock if she expects it to provide a 5% return, but if the Fed raises interest rates, investors will require higher returns for holding stocks.

We can perform a crude stock valuation by assuming a stock will pay a constant dividend forever (a perpetuity) and investors’ returns are derived solely from dividends. Under this assumption, the price, or present value, of a stock simplifies to:

Present Value of Stock = Dividends per Share / Interest Rate

Suppose IBM's stock earns $1 per share. At an interest rate of 5%, the present value of IBM's stock is $1 / 0.05 = $20. If tightened monetary policy raises the interest rate to 6%, our crude valuation model predicts the stock’s value falls to $1 / 0.06 = $16.67. If dividends per share remain constant, an increase in the interest rate reduces stock values.

1. According to this valuation model, what happens to stock prices (present value) when the Fed targets lower interest rates?

2. Peoples' expectations about interest rates or dividends per share change stock values as well. Excessively tight monetary policy (higher interest rates) can lead to an economic recession. What happens to corporate profits during recession? If people expect that tight monetary policy will lead to recession, what will happen to stock values?

3. How did Ms Bartiromo's report about the Fed chair's dinner party comments affect peoples' interest rate expectations? How will a change in interest rate expectations affect required returns and stock valuations?

4. The Federal Reserve is one of the only central banks without an explicit inflation target. As a result, there is still considerable guesswork involved in determining the Fed's tolerance for inflation--that's one reason the Fed chairman's offhand comments receive so much attention. Uncertainty about the inflation target makes it more difficult to anticipate monetary policy. In the absence of clear monetary policy goals, small bits of information that change expectations can disrupt financial markets.

Ben Bernanke is an advocate of explicit inflation targeting--publicly announcing an inflation target and committing the central bank to its achievement. Would an explicit inflation target take some of the mystery out of monetary policy? How would explicit inflation targets change the likelihood of another Bartiromo Affair? How might an explicit inflation target inhibit the Fed's use of monetary policy during an economic crisis?

Nell Henderson offers a more detailed account of the Bartiromo Affair in the Washington Post.

Vikas Bajaj discusses the links between Fed policies and changes in both American and foreign financial markets in a New York Times article.

The idea for the post comes from Paul Romer's Econ 510 community discussion forum. Thanks also to Chris Buzzard for shoring up the finance.

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  • At 2:42 PM, June 05, 2006, Blogger William Chiu said…

    The goal of the Federal Reserve is two fold -- to maintain price stability and low unemployment. Often times there is a conflict between these two goals, and it is up to the Fed to decide which goal is more important.

    Announcing an explicit inflation target is problematic in two ways:

    1. Explicit inflation targets MAGNIFY financial market fluctuations.

    The Fed has no a priori control over the inflation rate. The Fed's control of the federal funds rate has an effect on the inflation rate only if it sufficiently influences long-term rates. The problem lies in the fact that there is often a long lag between changes in short- and long-term rates. If the Fed announces a "5% medium term inflation rate" but misses that target, then financial markets will expect even higher rates in the next term and send shares plumetting (even though the Fed might NOT have to raise rates to achieve lower FUTURE inflation due to time lags). Investing in the stock market will be more risky with an explicit inflation target.

    Aside from monetary policy lags that might steer the Fed away from its explicit inflation target, exogenous shocks also further weaken the Fed's ability to meet its inflation target.

    2. Explicit inflation target WEAKENS the Fed's inflation-fighting crediblity.

    I mentioned two practical humps that prevent the Fed from acheiving its explicit inflation target: lags and shocks. But when the market sees that there are often gaps between the actual inflation rate and the target inflation rate, they will begin to doubt whether or not the Fed is actually an inflation fighter. It doesn't take much for the market to lose faith.

    And if the Fed changes the explicit inflation target, that will further cause additional rounds of Fed speculation.

    The alternative to explicit inflation targeting is IMPLICIT inflation targeting. Do what Greenspan did. Make policy is a secret room, and announce it with some justification to the rest of the world. More information isn't necessarily better for the economy.

  • At 8:33 AM, June 06, 2006, Blogger Brandon Fuller said…

    For more on the inflation targeting debate...

    In favor

    Paul Romer pointed his econ students to a working paper from the San Francisco Fed:
    Read the abstract and introduction. The authors find some evidence that explicit inflation targets anchor long-term inflation expectations.


    Wolfgang Munchau of the FT makes claims similar to William's but provides some evidence from Sweden to back them up:
    (Subscription required)

    Notice that quite a bit of the debate centers on what people mean by an explicit inflation target. Is it a policy mandate to keep inflation within a certain band? Is it simply a public announcement of the Fed's concensus on a range of inflation rates that constitute price stability? Opponents of more public targets tend to characterize targeting as a strict rule. Advocates seem to characterize targets as publicly stated goals that central banks are free to deviate from for as many as several years at a time.

    The debate continues...

  • At 3:17 PM, June 06, 2006, Blogger William Chiu said…

    Here's an article related to Bernanke and financial markets.

    "Bernanke came in with this reputation as a great communicator," said John Caldwell, chief investment strategist for McDonald Financial Group, part of Cleveland-based KeyCorp. "Most of us would choose to go back to the general confusion (former Fed Chairman Alan) Greenspan created."


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