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CENTRAL BANKS ARE PROPPING UP STOCK PRICES

Thorsten Polliet

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Mises Institute, Mises wire, April 11, 2019, 4 pgs.

 
 

Reviewer Comment:
A libertarian view of the current actions of the FED. No doubt true. The questions are: "How long can this continue? and what will happen when it ends?"

 
 

Dr. Polleit questions the actual effectiveness of central bank monetary policy in which the investors in the financial markets show great confidence. He asks the question: "What is the actual relation between the interest rate and asset prices, stock prices in particular?" To answer he proposes to examine the "Gordon Growth Model" which 'shows the functional relation between a firm's stock priceand its profit level. the interest rate, and thefirm's profit growth rate."

He provides the formula:
stock price=D/ (i - g) in which D=dividend: i=interest rate; g=profit growth.
For example, he gives a D=$10 - - i=5% and g=0% the stock price is $200 - this results in ( 10/(.05 - 0)=200.
Then if g increases to @% the stock price should rise to $333.3.
If the central bank reduces the interest rate to 4% the stock price should increase to $500.
If g then decreases to 1% the price would decline back to $333.3 and if g declines further to .0005% the price would fall to $285.7
He provides a bar graph to depict this. He notes that according to the formula the central bank can increase stock prices by lowering the interest rate. But he asks "what about the effect the interest rate has on firm's profit growth?"

 

Dr Polleit states that if the bank sets interest rates very low that could take the energy out of the market. It could allow unprofitable businesses to continue which would impact better businesses. That would then have a serious effect on product markets, "resulting in lower growth and employment." In turn that would cause the government to increase deficit spending, thus diverting still more resources to unproductive purposes.

 
 

He describes a cascading situation in which the central bank policy of very low interest rates generates increases in stock prices for a while, but then investors recognize the problem and reverse their belief in future business increase. Once their selling of stock begins it will cascade into more and more selling. The decline in stock prices then would impact other asset prices - for instance raw materials, housing, and industrial goods. All this would trigger defaults in the credit markets making it difficult for debtors to service their debts.

 
 

He asks the question: if and when the government via the central bank then attempted to support the credit markets by creating more 'money' to whom would it give the new money? Who would know how much 'new money' to create?

 
 

His point in this essay is to prove that the current monetary policy of very low interest rates is already producing harm to the economy. It is a 'self defeating' policy. And the longer the current policy continues the more dangerous it is.

 
 

 
 

 
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