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.