I’ve often argued that Fed policy should not try boost equity prices. It’s (at least) equally true that the Fed should not try to reduce equity prices. Not everyone seems to agree:
Sharp stock-market losses show investors have got the message that Jerome Powell and his colleagues are serious about tackling inflation, said Minneapolis Fed President Neel Kashkari.
“I was actually happy to see how Chair Powell’s Jackson Hole speech was received,” Kashkari said in an interview with Bloomberg’s Odd Lots podcast on Monday, reflecting on the steep drop after Powell spoke. “People now understand the seriousness of our commitment to getting inflation back down to 2%.”
This sort of comment sets a bad precedent. I have no objection to Fed officials being happy because markets take their comments seriously. Thus Kashkari might have cited the modest fall in inflation expectations (measured by TIPS spreads) during Powell’s speech.
But TIPS spreads are a nominal variable. Because the price level changes very little from one day to the next, a more than 3% drop in the stock market reflects implies an almost equally large drop in real equity prices. It’s hard to believe that monetary policies likely to improve our economy would cause real stock prices to fall by more than 3%.
Again, this doesn’t mean Powell should not be trying to reduce inflation expectations. At the moment, a tighter monetary policy is probably appropriate. But I don’t believe it is a good idea to use falling stock prices as a measure of success. If it were, then why stop with a 3% decline? The Federal Reserve of 1929 also tried to reduce stocks prices, and was far more “successful” in that endeavor than the Powell Fed. And we all know how that ended up.
READER COMMENTS
Matthias
Aug 30 2022 at 2:08am
I was thinking how changing expectations of the future path of the price level might make a sudden drop in stock prices defensible.
But I don’t think that line of reasoning works. So you are absolutely right in ridiculing the glee.
Spencer Bradley Hall
Aug 30 2022 at 11:25am
That’s why Bernanke censored the FED’s technical staff (pre GFC).
Andre
Aug 30 2022 at 3:59pm
I’m puzzled by this post’s criticism. Stock prices are inversely related to interest rates as they’re basically the present value of future dividends. In order to lower inflation, the Fed wants to discourage present consumption, lowering aggregate demand, which it does by raising interest rates and thus shifting consumption to the future/increasing savings. But if the (interest rate) increase is credible, it also reduces present l value of future cash flows, hence lowering stock prices. I.e., a drop in the stock market indicates the credibility of the Fed’s actions and thus is a good sign. It’s not like anyone is celebrating/defending lower (future expected) profits.
vince
Aug 30 2022 at 9:48pm
The argument is that a good economic policy–stemming inflation–should be good for the market. Maybe the market never believed inflation was a threat.
Scott Sumner
Aug 31 2022 at 1:34am
Stocks can fall for many reasons. In the 1930s, stocks fell due to excessively tight monetary policies. From 1966-81, stocks fell due to excessively expansionary monetary policies. It should never be the Fed’s goal to reduce real stock values.
Under most circumstances, stocks do better when monetary policy is more stable.
Jose Pablo
Aug 31 2022 at 6:51pm
“Stock prices are inversely related to interest rates”
Are they? … why should?
To real interest rates or to nominal interest rates?
Why should witnessing the commitment of the FED with a policy that should improve the American economy (and by doing so the future earnings of American companies) reduce the value of this companies’ shares?
For different interest rates paths you should get different earnings. The “right” interest path should maximize earnings (having the “right” economy should be good for businesses) and so the value of the American companies.
Maybe the markets are thinking that the FED is going to raise interest rates to high, damaging the economic future outlook. That would explain the drop. But if the FED is doing the right thing, shares should go up on that news (and just the fact that many other things are happening at the same time should be, also, kept in mind).
Unfortunately, or so it seems, for Minneapolis Fed President Neel Kashkari the FED’s job is maximizing the value of american companies by “optimizing” the future growth of the American economy … unless they are “overdoing” (or “underdoing” like last year).
derek
Sep 2 2022 at 11:16am
Modern finance views stock prices as the future stream of income for a company, discounted to infinity. When the Fed raises the interest rate, the discount rate also rises, so the company’s share price goes down without any change to fundamentals.
Jose Pablo
Sep 2 2022 at 12:28pm
No.
You are assuming that the FED induced increases in interest rates will not affect the value of the “future stream of income” in your model.
But the whole purpose of the increase in interest rates is to “improve” (or so we have to hope) the “future stream of income” of American companies.
As far as the FED’s “sheepherding” of the American economy results in a “bigger” economy (and that’s the ultimate goal of its dual mandate), shares are more valuable when the FED does the “right thing”. No matter if it is lowering or increasing interest rates.
The opposite (shares are less valuable when the FED makes mistakes) it’s also true. And that is what should worry Mr Kashkari taking into account how prone the FED is to making them.
Jose Pablo
Sep 2 2022 at 12:47pm
Even if you make the “basic” assumption that shares are “real assets” and so the “nominal future stream of income” should increase with inflation to keep its real value; an increase in nominal interest rates that represent a decrease in real interest rates (basically what we are witnessing today) should increase the discounted value of your model.
Just don’t assume in your valuation models that interest rates and “future streams of incomes” are independent variables. They are not.
John Stalnaker
Aug 31 2022 at 9:31am
The word is Schadenfreude
Jose Pablo
Aug 31 2022 at 8:45pm
“People now understand the seriousness of our commitment to getting inflation back down to 2%”
That’s really unfortunate: if “your commitment” is the right one for the economy and people “understand your seriousness” with something that is good for the economy, why should share prices go down?
On the other hand, your seriousness could be bad for the economy (and would make prices go down) if it is a seriousness with the “wrong” policy. After all, it would not be the first time that you are “very serious” with the wrong commitment.
You should be worried, not happy, if markets seem to believe so.
[Or maybe the markets were thinking that the inflation problem was already under control and insisting in the “seriousness” of your commitment show them that you believe otherwise]
Rodrigo
Sep 1 2022 at 9:48am
Professor,
I am a bit confused by the market reaction to Powell, Kashkari and Mester. Publicly stating they intend to go higher for longer should be contractionary. This should have lowered stock prices which it did, but also reduce longer term rates but instead they have moved up while inflation expectations moved down (slightly). You used to say that in order to create inflation the fed should promise to go lower for longer until long rates moved up. Now rates are moving up by promising to the the opposite? Am I completely missing something? Could it be stocks were wrong in that inflation was not under control and bonds correct in that higher for longer is appropriate?
Jose Pablo
Sep 1 2022 at 7:19pm
“they intend to go higher for longer should be contractionary. This should have lowered stock prices”
why “FED induced” higher (and for longer) interest rates should lower stock prices?
Imagine two scenarios:
scenario a). The FED thinks, let’s say for instance, that inflation is transitory and does NOT move up interest rates. As a consequence of this course of action, the American economy suffers a kind of Germany 1923 hyperinflation (I am not saying this is a realistic possibility, just trying to illustrate an idea)
scenario b). Every other factor that could move the markets is like in scenario a, but the FED raises interest rates (higher and longer) and, as a consequence of that, inflation gets under control and the American economy grows in a steady and orderly manner
If the markets think we are in scenario a, and suddenly realize (lets say that thanks to a FED’s President speech) that the central bank “strong commitment” with the new policy will move the economy to scenario b, stock prices should raise on this news. And should rasie precisely BECAUSE of the increase in interest rates.
Afterall, stock values should be higher in scenario b, don’t you think?
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