Central Banks Are Propping Up Stock Prices

Monday, April 15, 2019
By Paul Martin

April 15, 2019

There seems to be a great deal of confidence in the effectiveness of central bank policy, but savers & investors might want to think carefully about that…

by Thorsten Polleit via Mises Wire

Financial markets seem to have a great deal of confidence in the effectiveness of central bank monetary policy — in the sense that by keeping interest rates low, or bring interest rates down, the economies will keep expanding and asset prices, in particular, will keep rising. There is, however, good reason for savers and investors alike to think very carefully about the truth value of such a proposition.

The key question is this: What is the actual relation between the interest rate and asset prices, stock prices in particular? To answer this question, it may be helpful to take a brief look at the well-known “Gordon Growth Model”. It shows the functional relation between a firm’s stock price and its profit level, the interest rate, and the firm’s profit growth rate. The formula is:

stock price = D / (i – g),

whereas D = dividend, i = interest rate, and g = profit growth.

If, say, D = 10 US$, i = 5% and g = 0%, the stock price is 200 US$ [10 / (0.05 – 0) = 200]. If g then goes up to 2%, the stock price rises to 333.3 US$. If the central bank lowered the interest rate to 4%, the stock price goes up further to 500.0 US$. Should g then drop to 1%, the stock price would decline back to 333.3, and if g falls even lower to 0,005%, the stock price falls to 285.7.

The Rest…HERE

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