The View from Vienna on Interest Rates and the Stock Market

Interest rates have some impact on the stock market because if investors can earn a better return in bonds than in the stock market and with less volatility they will sell stocks and invest in bonds. A large part of the recent record highs in the stock market reflect the Fed’s squashing of interest rates. The Fed wants to punish savers and reward debtors.

Interest rates have been falling since the early 1980’s to near zero today. According to the Financial Times columnist, Gavyn Davies, my main source for what central bankers are thinking, the International Monetary Fund identified three main reasons for the decline depending on the period:

1. In the 1980’s and 1990’s Fed inflationary policies caused the drop.
2. Since 2008, businesses have quit investing.
3. 2002 – 2007, the savings glut from emerging markets kept rates low.
4. Since 2000, portfolio shifted to bonds because of two stock market crashes.

The IMF predicts interest rates will rise to only 1.25% by 2018. Here are Davies conclusions:

1.             If the global real long term rate rises to only 1.25 per cent in 2018, the equilibrium nominal bond yield (with inflation expectations at the 2 per cent target) will be only 3.25 per cent, suggesting that any further bear market in bonds will be limited in scale from here.

2.            The equilibrium real short rate in the next era should be well below the 2 per cent built into conventional monetary policy rules prior to 2008. This will restrict the extent of central bank tightening up to 2018 (assuming that Ms Yellen et al believe this research, as they probably do).

3.            Those of us who have been worried about the rise in public debt in Japan, the UK and the euro area periphery (not the US or the euro area as a whole) may have been exaggerating the risks that budgetary policy in these regions is in imminent danger of becoming unsustainable. More on this another time.

I agree with the IMF analysis except for the “savings glut” (as Greespan called it.) Macro economists forget that emerging markets such as China don’t print $US. Iran does, but that’s a story about counterfeiting. China can’t get dollars except by selling stuff to US citizens. Mises reminded us that consumers buy more imports when the central banks try to make them hold more cash than they want. They “export” the excess by purchasing foreign goods. So the “savings glut” is nothing but the flip side of the inflationary policies of the Fed.

Also, businesses are sitting on mountains of cash and refusing to invest in the US, but not for the reasons the IMF gives. High tax rates and regulation make investing in the US an ugly prospect.

I think Davies and the IMF are a little too optimistic. Both assume no recession in the near future because interest rates are low. But Hayek demonstrated in Profits, Interest and Investments that recessions can happen even if banks don’t raise interest rates. The trigger is the Ricardo Effect in which increased consumer spending shifts profits toward consumer goods producers and away from capital good producers.

Hayek’s explains the Ricardo Effect in Profits, Interest and Investments and Pure Theory of Capital. Jesus Huerta de Soto has a good explanation in his Money, Bank Credit and Economic Cycles and I use the micro tool of the production possibility frontier, which I borrowed from Roger Garrison, showing the trade-off between capital and labor to explain it in Financial Bull Riding.  

BTW, government borrowing as a percent of GDP has reached levels not seen since World War II – 120%. So what happens if the US hits another recession in the next year or two with interest rates so low and debt so high? The stock market will crash with the economy, but the Fed will have no room to maneuver and reduce interest rates. It will probably launch another round of QE. Governments will have no choice but to borrow and spend again, raising the debt/GDP levels to historic highs.

Gold looks more seductive all the time.