Academic journal article Economic Perspectives

Interest Rates and Asset Prices: A Primer

Academic journal article Economic Perspectives

Interest Rates and Asset Prices: A Primer

Article excerpt

Introduction and summary

Economic commentators often assert that major asset price booms and busts are closely associated with variations in the terms of borrowing to fund risky asset purchases. One important narrative focuses on changes in borrowing costs arising from variation in the risk-less interest rate, which may result from a variety of causes--notably central bank policy actions in the short run and changes in world saving and associated capital flows over a longer horizon. For example, Allen and Gale (2000) contend that so-called bubble episodes typically begin with "financial liberalization or a conscious decision by the central bank to increase lending." After a period of perhaps several years, these authors continue, the central bank's policy stance tightens, interest rates rise, and the bubble collapses. (1) Greenspan (2010) also notes a connection between interest rates and asset prices but stresses the role of global savings patterns and other determinants of long-term rates rather than the short-term policy rates that are most closely connected to the actions of central bankers. (2)

What does economic theory have to say about the extent to which exogenous changes in short-term and/or long-term riskless rates ought to affect asset prices, and by what channels? In this article, we examine the implications of three key theoretical models of asset booms and busts, focusing on a variety of channels through which interest rates might affect real asset prices.

After providing a bit of empirical motivation via a brief look at data from Japan's stock and land price boom and bust of 1985-91, we study implications of the central model of traditional asset pricing, in which price is simply expected discounted future dividends. Here the focus is on the way in which the riskless interest rate affects the fundamental value of assets. Leverage does not play a central role because of the celebrated Modigliani-Miller theorem, which says that the total value of titles to an asset's payoffs is independent of how they are divided into debt and equity claims. Using first the simple Gordon formula, and then Campbell and Shiller's log-linearized dynamic Gordon model, we derive quantitative implications for the effects of innovations in the short-term rate on an asset that could be thought of as land or the stock of an unlevered firm.

The key result of this perfect markets model is that the extent to which increases in the riskless interest rate lower fundamental asset values is an increasing function of the persistence of short-term interest rates and a decreasing function of the risk premium. This observation has important implications for debates over whether or not central banks are likely to cause large cycles in real asset prices by varying policy rates. In order to have such effects in this standard model, central bankers must be able to create highly persistent changes in real policy rates--put differently, they must exert major effects on real long-term interest rates. Monetary theory, however, suggests that the ability of central banks to effect permanent changes in real rates is limited (Shiller, 1980). (3) These two observations in combination suggest that central banks also have limited ability to create booms and busts in real asset markets.

While traditional asset-pricing theory focuses on fundamentals--discounted future real cash flows--there are alternative theories in which market imperfections play an important role. One such model, originating with Allen and Gale (2000) and developed more fully in Barlevy (2014), is based on the idea that "speculators" borrow (without sufficient collateral) from "banks" in order to buy risky assets. Banks are unable to differentiate between "entrepreneurs" that are safe to lend to and speculators that default if the payoff from the asset is disappointing. In this model, the price is pushed above its (social) fundamental value because of the default option. …

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