Central banks, asset markets and the economy
by George Hatjoullis
In finance an asset value is usually characterised as the discounted present value of the prospective stream of net cash flows that the asset is expected to generate. The discount rate is conceptualised as having two components; a risk free interest rate and a risk premium. The risk free rate is, as the name implies, the interest rate that one can achieve by lending at no risk over the relevant period. It is usually approximated by some government bond yield. The risk premium reflects an addition to the interest rate to allow for the probability that the prospective stream of net cash flows fails to materialise. The higher the risk free rate and the riskier the prospective stream then the greater the discount rate and hence the lower the present value of the cash flows. The lower the value of the asset. This much is available from any introduction to finance.
One of the operational problems with this characterisation is that the three components as not independent. Changes in interest rates affect the cash flows and thus prospective interest rate changes affect the risk premium. The single most important determinant of interest rates is the central bank and the reason for using this Finance M101 framework is because it makes explicit the nature of central bank policy in the last 5 years or so. Central banks have kept interest rates at historically low levels. Moreover they have been at pains to ensure the whole yield curve is lower through quantitative easing. Furthermore they have made a big song and dance, called forward guidance, about how any increases in interest rates will be gentle, predictable and probably end long before the levels usually reached at point of exit from the rate increase cycle. In short they have done everything within their power to boost asset prices and to keep asset prices stable at elevated levels. If indeed there are bubbles in asset prices then the central banks can reasonably be held responsible. This was always a risk of their policy. The question is why adopt such a policy?
The banking crisis broke the credit creation mechanism. Banks were unable and unwilling to lend after 2008. Indeed they have spent much of the period since contracting their balance sheets. This had an enormously negative effect on the economies. Conventional monetary policy works through encouraging banks to lend. This route was not available to the central banks. They opted for one of only two approaches left to them which was to generate a ‘wealth effect’. Wealth growth encourages people to spend and invest more, at least in absolute terms. It is a very blunt tool and has unfortunate distributional consequences but in the circumstances it was a reasonable approach. Economists have traditionally doubted the power of wealth effects so the effect had to be fairly substantial to make a meaningful impact on the real economy. It seems to have worked in that economies are in better shape now than they were. However, the capacity of the central banks to boost wealth has been spent. The CB effect on wealth is fully impacted in current asset prices. The best they can do now is sustain the effect at current levels. The whole point of forward guidance is not to generate a precipitous collapse in asset prices as the official interest rate is raised.
Different central banks are at different stages of this policy. The UK and US authorities are looking for the exit. The Bank of Japan is in the middle of an asset enhancing exercise. The ECB has barely begun and if it does not get a grip soon will find the eurozone in a very difficult deflation. The other policy tool that none of the banks will contemplate or cannot contemplate is deficit financing of government expenditure. This has been discussed at length in blogs all the way back to the first few. It is possible that the BoJ may yet need to find some way to adopt this policy. The ECB may need to but there is no conceivable mechanism whereby it could adopt such a policy. The UK and US authorities have, by early and effective action, avoided the need. So what happens to asset prices now where the central bank boost has run it course?
Asset prices must now find reasons to grow beyond suppression of the discount factor and indeed must offset some enlargement of the discount factor. The earnings that drive net cash flows need stimulus from the economy, from productivity and from investment. For the last few years asset prices have led the economies. Now they must be led by them. Further asset growth needs positive earnings surprises. Moreover, earnings disappointment may result in disproportionate falls in asset prices as anxiety boosts the risk premium once again. According to Morgan Stanley as reported by the FT, this is precisely what is happening now.
The narrative is slowly changing and investors are coming to realise that continued central bank accommodation merely sustains current prices. It cannot any longer advance them. Only strong economy outcomes as expressed in earnings can now advance asset prices further. The complication is that the markets also fear that if economies advance too quickly the pace of central bank exit will accelerate and potentially overwhelm the benefits of earnings growth. Historically this is a legitimate fear. However, in the present circumstances, with inflation well behaved, this fear is misplaced. Markets should welcome strong economy outcomes now but it may take a while for this narrative to take hold. In the meantime asset prices have reached a top. This does not mean a bear market will take hold but rather a volatile sideways move is in progress. Of course a bear market is always possible if policy makers get carried away and misjudge the resilience of the economies.