Tuesday, September 14, 1999

Words from the wise man

By Martin and Kathleen Feldstein

"Links between share prices, Greens pans monetary policy

Wyoming's Jackson Hole and the Grand Tetons provided a beautiful setting for a Federal Reserve conference we attended at the end of August. Fed chairman, Alan Greenspan, delivered the opening speech at the Fed meeting and a printed version of his remarks was released to the press just before the opening of the stock market.

The very fact Greenspan focused his talk on share prices was enough to cause the market to decline sharply at the opening. In fact, though, there was nothing in his remarks to warrant such a reaction. If anything, the opposite was true. He did refer to rising asset prices, but made it clear their link to monetary policy was indirect and not a reason for monetary tightening.

Greenspans scholarly speech reminded his audience - central bankers, economists, and financial analysts - that share prices reflect the expected value of future earnings and the amount investors are prepared to pay today. Future earnings are of course uncertain and depend on how the economy evolves. But even current earnings are ambiguous. Greenspan noted there are offsetting factors at work in the accounting calculation of corporate earnings that may or may not balance out.

For example, the accounting measures of corporate earnings are overstated by omitting a charge against earnings for the cost of options - an increasingly important form of consumption.

At the same time, financial statements generated by standard accounting rules also underestimate true earnings in other ways. For example, outlays on software and advertising that add to earnings for many years are treated as current costs rather than as investment.

Although share prices vary inversely with the level of interest rates, Greenspan emphasized it is just the level of rates that determines how expectations of future earnings are translated into todays share prices.

Because of the riskiness of shares, investors expect a higher yield, or total return including dividends and capital gains, on corporate shares than on bonds.

The real interest rate net of inflation on long-term government bonds is now about 4 percent. The yields on corporate shares vary a lot across industries, but a typical share might have a price-earnings ratio of 10 to 16, implying an expected earnings yield of 6 to 10 percent.

The difference between that yield and the long-term bond rate is the risk premium or reward for taking on extra risk. Greenspan stressed that the risk premium on shares reflects psychological and confidence factors that could easily swing abruptly, raising or lowering share prices. Perhaps that is a useful warning.

What are the links between share prices and monetary policy? Some of the news reports and headlines that weve seen about the Wyoming meeting have interpreted Greenspans remarks to mean the Fed will raise interest rates if share prices continue to rise.

But there was nothing in his comments to suggest the Fed would take such steps. The Fed focuses primarily on inflation and sustainable growth. Because it is concerned about future inflation, it looks at pressures on demand and here is the indirect link to share prices.

Consumers and businesses spend more when share prices are high. Evidence indicates that high share prices, by increasing wealth and making saving less necessary, may explain most of the decline of the saving rate to zero over the last decade. In addition, as economists Ben Bernanke and Mark Gertler explained at the Fed meeting, total spending is increased because higher asset values improve the quality of the balance sheets, enabling individuals and corporations to borrow more.

Its no surprise that share prices are one aspect of what drives aggregate demand and inflation. But as Greenspan has noted on many previous occasions, there are many other factors that affect future inflation, including the exchange rate, tightness in the labor markets, the level of economic activity among our trading partners, and energy prices.

Greenspan took an opportunity later in the discussion to amplify on his prepared remarks. He commented that central banks worldwide do not react to gradually rising or gradually falling share prices but do react when there is a sharp movement in share prices.

But he added there is an asymmetry, with sharp price changes much more likely in a declining market than in a rising one. The Fed did of course react to a sharp collapse in share prices in 1987, when the Fed rescued the market by pumping in liquidity. Failure to do that could have caused an economic downturn.

Not everyone would agree that the Federal Reserve should ignore the rise in share prices as such and look only at their impact on aggregate demand and inflation. Such critics of the Feds approach would argue as follows: If a sharp collapse would hurt the economy, and an overvalued market is more likely to crash, shouldnt the Fed do something to rein in what Greenspan once called the "irrational exuberance" of the market?

Its true that raising interest rates above the level called for by the inflation outlook might lead to a stronger dollar and indirectly to slower economic activity. But that might be a price worth paying to reduce the risk of a future sharp fall in share prices.

But these were not the views of Greenspan at the Jackson Hole meeting. That doesnt mean he thinks the stock market is now reasonably priced or that interest rates wont keep rising if inflationary pressure continues to build. But there was nothing in his remarks to suggest the Fed would focus on rising stock prices as such when it next considers whether to raise rates.

Martin Feldstein, the former chairman of the Council of Economic Advisers, and his wife, Kathleen, also an economist, write frequently together on economics.