Here’s a very simple (and totally inadequate) theory of the rate of interest: it is set by the Bank of Canada. Add or subtract adjustments for risk, duration, liquidity, and earnings growth, and you get the equilibrium earnings yield on stocks. Take the reciprocal, and you get the P/E ratio. Done.
Why is that theory totally inadequate? Because the Bank of Canada does not set interest rates in a vacuum. It sets the rate of interest it thinks it needs to set to keep inflation at the 2% target. And that interest rate in turn depends on things like the demand for goods, and the Phillips Curve, and on the inflation target. And the demand for goods in turn depends on things like desired saving and investment, both in Canada and around the world. And those in turn depend on time-preference, and expectations of future income, and on the marginal rates of transformation of present goods into future goods, and whether there will be a demand for those future goods or a recession.
Read the whole thing.
This first paragraph reminds me that I have meant to write an imaginary Q&A with Scott Sumner.
Q: Why did the stock market go up about 2 percent the other day?
SS: Because the Fed announced an expansionary policy.
Q: But the Fed announced that it was tapering its purchases of assets, although they issued a “forward guidance” that interest rates would remain low. Given the somewhat contradictory announcement, how do we know that it was expansionary?
SS: Because the stock market went up about 2 percent.
Nick’s second paragraph reminds us that central bank policy is also endogenous. That is the way that I think of it.
So what’s my explanation for the rise in the market, which was obviously in response to the Fed announcement? A couple of possibilities.
1. Perhaps they read the taper announcement as an indication that the Fed has information that the economy is doing well. They took it as good news.
2. Perhaps a few key Wall Street gurus interpreted the announcement as good news, because of (1) or because they are devoted followers of Scott Sumner or because of the meds they were on or whatever. Then everyone else realized that if the gurus were optimistic then stocks would go up, so they pushed stocks up. It was collective irrationality. As Fischer Black famously said, the stock market is efficient only to a factor of 2.
The way I reconcile finance with macro is that I minimize the weight I give to macro. Markets are happy to let the Fed wiggle around an interest rate or two, as long as it does not wiggle too hard on an interest rate that really matters to the economy. If the Fed were to wiggle too hard on a rate that matters, the markets would find a way around that particular part of the money market in order to make that interest rate matter less. As an economist, your best bet is to treat interest rates and stock prices as determined by financial markets, rationally or otherwise (I vote otherwise), and not by the Fed.