I’m not sure that equity market investors have fully taken on board the full implications of the policy change that Jerome Powell at the US Federal Reserve announced recently. A couple of canal barges, the narrow ones that go through the eighteenth century locks on Britain’s oldest canals, can help explain why.
Canal Barges and Tobin’s Q
As an undergraduate at Oxford in the early 1970s (yes, a while back!), I was wandering along one of the canal towpaths in a bit of displacement activity to avoid actually writing my essays, when I saw a couple of those narrow boats up for sale. They looked in great condition, almost new, but the price, I can’t remember but say £100 or so, seemed absurdly low compared to what it would surely cost to build a brand-new one. Now, maybe there was something horribly wrong with them (though they seemed to float just fine), but the stock market, along with house prices, were in a deep slump at the time, so it made sense that second-hand boat prices would also be rock-bottom. It suddenly struck me: why would anyone buy a new one, when a good used one was a fraction of the price? Not just the sort of discount that gets measured as a percentage, as there always is on things like slightly-used cars, but a reduction measured in multiples, one-quarter of the brand-new price, or something like that.
J M Keynes and Tobin’s Q
That really brought Tobin’s Q alive for me. This jargon term, coined by the great James Tobin, is the ratio of the market price of an asset, to the cost of making a new one. It’s sometimes used to try and evaluate stock markets, but its real power comes when applied much more broadly. The canal boats instantly showed me that the economy was going to stay in a slump, so long as asset prices were crazily low. Why would anyone buy a new boat, when they could get a good slightly-used one for vastly less money? Same for a company thinking of building a new factory, a person buying a house, etc.
I did go to the library after that, and I found that the (then) recent re-interpretation of Keynes by people like Axel Leijonhufvud and Bertie Hines put Tobin’s Q at its heart. Their re-reading of Keynes was that he saw asset prices as central to economic slumps: when they were (far) below replacement value, no-one would want to invest in new stuff since they could buy old stuff cheaper, and the lack of investment would create a downward multiplier that would drive the slump even deeper. Later on, I wrote a rather technical article about all this, somewhere in Oxford Economic Papers in the unlikely event that you’re interested.
Boosting asset prices was central to breaking this vicious circle. And how did you do that? Cut interest rates, of course, but there came a limit for that process, once they got to around zero. So in Keynes’ world, that left only fiscal expansion as the way out, but note the re-interpretation: the key objective of that was to boost asset prices.
QE and Tobin’s Q
Fast-forward to the 21st century, and this kind of thinking now underlies much of the new conventional wisdom, even though it’s been modified a bit, re-branded and doesn’t acknowledge those antecedents very explicitly. Quantitative Easing (QE), where central banks buy lots and lots of assets (government bonds, privately-issued bonds, even equities in some countries) is one key strand of this. Buying assets directly is almost certain to push up their prices, especially when combined with zero-ish interest rates. And chuck in a bit of fiscal expansion as part of the mix. Of course, neither central banks nor governments buy canal barges directly, but a rise in the price of one kind of asset sooner or later percolates through to other types, and that supports capital investment, lifting the economy out of a slump, or stopping it going into one.
Now, central bank policy is still officially focussed on consumer prices, it has never been explicitly about asset prices. There are all sorts of reasons for that, partly because the central banks don’t like to confuse people by changing headline targets, so they’ve still got the 2% consumer price inflation target dating back to Bank of Canada work in the early 1980s. Partly because asset prices are slippery beasts that can move around far too much to be useful for policy-making, and anyway can be impacted in crazy ways by the merest hint that the authorities are even thinking about them. Despite all this, asset prices have clearly been utterly crucial for central bank policy for at least the last decade.
The Fed and Tobin’s Q
And that brings us to Jerome Powell’s recent policy shift. Having spent the last ten years, on and off, buying bonds so as to get their prices up (which mechanically means that their yields go down), a lot of investors were thinking that he would support the recovery from Covid by shifting to a new policy that included an explicit, very low target for bond yields. Especially since the Bank of Japan has been doing just that for some time. No-one expected the target to be as low as in Japan (where it’s zero), but any figure significantly below current levels would set financial markets on fire, since bond yields help determine today’s value for an expected future stream of corporate profits. The lower that bond yields are, the more those future profits are worth, and stock market prices are likely to rise to reflect this. That in turn should stimulate the economy, partly via the Tobin’s Q effect.
But, Mr Powell, in two or three recent speeches, has made very clear that the Fed has considered targetting bond yields, and explicitly rejected the idea. Instead, they’ve in effect announced that they will be keeping short-term interest rates at around zero for the next three years or so, more or less regardless of what happens to inflation. That’s a very strong commitment. But they’ve also made clear that they won’t be targetting longer term bond yields, whether for ten-year bonds, or 30-year, or whatever. That’s also a strong statement, compared to what investors had started to think.
Now, that set of policy statements didn’t cause bond yields to shoot upwards, for two very good reasons. Partly because the Fed, alongside other central banks, is still buying a lot of bonds through its QE programme. And partly, because the yield on a ten-year bond can be thought of as the weighted average of the current yield on a three-year bond, and the expected yield on a seven year bond issued in three years time. Since the Fed’s promise anchors the first of those firmly at zero, and there was no particular reason to revise up expectations for the second, ten-year bond yields didn’t shoot up.
Nevertheless, there is a kind of wake-up call here. The Fed is telling us that longer-dated yields are being held down for the moment, but they are also warning that if inflation starts to rise too much, or the economy recovers rapidly, then they will be allowed to rise in future. That’s quite a change from where investors were beginning to think we were.
Tech stocks and Tobin’s Q
The stock market has kind of started to take this on board. Arguably, it’s no coincidence that the technology stocks that had been making so much of the running, have lost their seemingly unbreakable upward momentum and become very volatile, on some days leading the broader market down. The income from those stocks is far in the future, so even the possibility that bond yields may rise later on, means that the very high valuations they enjoyed are that little bit more difficult to justify.
So has the Fed implicitly abandoned efforts to use Tobin’s Q to stimulate the economy? Not at all. By sitting hard on short rates for the next three years, they are keeping asset prices high for now, and that ought to allow Q to do its magic, persuading investors to build new stuff rather than buying old stuff cheap. But by giving the hint about future longer-dated bond yields, the Fed is taking a bit of froth out of some of those technology stocks. Other stocks, where it’s the next few years of expected earnings that are more relevant than the distant future of the tech stocks, are better protected by this configuration of bond yields, and the price action has tentatively started to reflect this. I think this is a new trend that could go a quite a bit further.
Sean Shepley kindly made valuable comments on an earlier version of this draft. All remaining errors and problems remain my responsibility.
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