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"HOW HIGH IS UP? Address by Theodore H. Roberts President Federal Reserve Bank of S t . Louis Before the St. Louis Chapter of the Financial Analysts Society Missouri Athletic Club October 20, 1983 I am especially pleased to have this opportunity to speak to the St. Louis Chapter of the Financial Analysts Society. One of my earliest business assignments was serving Harris Bank as a financial analyst. During that period I was a card carrying member of the Investment Analysts Society of Chicago. I followed bank and insurance stocks, primarily, but I also kept an eye on finance companies, savings and loans, and mutual fund management companies. During that time I was a member of the Subcommittee on Bank Reporting of the Corporate Information Committee of the Financial Analysts Federation and was involved in the recommendations for improving bank earnings statements. Later as chief financial officer, I marveled at the wealth of information which we routinely made available to bank stock analysts. While my principal problem as a bank stock analyst was obtaining adequate information, it seems to me that today the biggest problem for an analyst is determining what part of the wealth of information is important. I also had the duty of managing investor relations and some of you called on me to discuss your holdings. In view of the recent Canadian interest in Harris, I hope you held on to your stockl October, Mark Twain once wrote, is one of the most dangerous months in which to speculate 2jn_ stocks. He noted that the other especially dangerous ones were July, January, September, April, and all the other months. Having been so warned, I am not here today to speculate in stocks. Instead, I would like to speculate about stocks. That is, I would like to speculate about the factors that have influenced the behavior of equity values over the past several years and that are likely to continue to do so into the future as wel 1. At the present time, the economy is robust, unemployment is declining and inflation is remarkably low. During the past year, virtually across the - 2 - board, stock market i n d i c a t o r s were pushing up i n t o previously unexplored territory. "Record highs" were reported so f r e q u e n t l y t h a t such announce- ments were almost commonplace. Of course, t h i s was before the computer companies s t a r t i n g s u r p r i s i n g us. Unfortunately, i n my o p i n i o n , the euphoria associated with recent share p r i c e r i s e s has served t o m i s d i r e c t public a t t e n t i o n from c e r t a i n fundamental questions about stock market behavior--both past and f u t u r e . When I read t h a t the stock market values are "up" t o record highs, I am reminded o f the childhood conundrum: "How high i s up?" In r e a l terms, a f t e r adjustment f o r i n f l a t i o n , stock prices are nowhere near record l e v e l s - - i n f a c t , they are now about where they were 30 years ago. In r e a l terms, stock prices peaked i n the l a t e 1960s and declined s t e a d i l y t h e r e a f t e r . While the stock market indices have been generally r i s i n g t o nominal record highs since the l a t e 1960s, i n r e a l terms, shareholders, t o quote Twain again, "have been f a s t r i s i n g from affluence t o p o v e r t y . " The fundamental question t h a t must be answered, i f we want t o understand both the past h i s t o r y and f u t u r e prospects f o r e q u i t y values, i s n o t , "Why are stocks doing so well now?" The important question i s "Why have stocks done so badly over the past f i f t e e n years?" From 1950 t o the l a t e 1960s, r e a l share prices were generally r i s i n g ; over the past f i f t e e n years, they were generally f a l l i n g . The c h i e f d i f f e r e n c e between these two periods i s t h a t there was l i t t l e or no i n f l a t i o n i n the e a r l i e r p e r i o d , but generally r i s i n g and e r r a t i c i n f l a t i o n i n the l a t t e r p e r i o d . The o l d adage t h a t stocks were a good hedge against i n f l a t i o n turned out t o be dead wrong. And t h e r e i n l i e s the puzzle. We a l l know, or at l e a s t t h i n k we know, why higher and more uncertain i n f l a t i o n has adverse e f f e c t s on the bond markets. But why a r e n ' t stocks, which presumably represent some underlying - 3 - " r e a l v a l u e s " , immune from the impact of i n f l a t i o n ? With the 20-20 v i s i o n t h a t always comes w i t h h i n d s i g h t , we can see c l e a r l y t h a t i n f l a t i o n adversely impacts on share prices f o r several reasons. F i r s t , because depreciation charges are based on h i s t o r i c costs rather than on c u r r e n t replacement c o s t s , p r o f i t s are overstated and the f i r m ' s r e a l taxes r i s e . I n f l a t i o n i s , a f t e r a l l , a t a x ; one t h a t f i r m s are u n l i k e l y t o t o t a l l y avoid paying. Second, higher and more v a r i a b l e i n f l a t i o n produces greater u n c e r t a i n t y about the f u t u r e purchasing power of money and the value of bonds and stocks. This increased u n c e r t a i n t y pushes up the r e a l r a t e of i n t e r e s t t h a t must be o f f e r e d t o p o t e n t i a l and e x i s t i n g shareholders. T h i r d , the greater uncer- t a i n t y about f u t u r e values shows up also as a movement up the q u a l i t y scale and down the m a t u r i t y spectrum i n terms o f asset h o l d i n g s . This attempt t o increase the l i q u i d i t y o f investments produces f u r t h e r downward pressure on stock p r i c e s . F i n a l l y , there i s some evidence t h a t firms have attempted t o maintain the r e a l value of t h e i r dividends i n the face of r i s i n g i n f l a t i o n , even though t h e i r r e a l a f t e r - t a x earnings were d e c l i n i n g . In so d o i n g , they were simply paying out c a p i t a l - - i n other words, p a r t i a l l y l i q u i d a t i n g the f i r m s over t i m e . This being the case, i t should surprise no one t h a t stock prices f e l l i n r e a l terms over t h i s period.. Thus, despite widespread notions t o the c o n t r a r y , i n f l a t i o n i s neither good f o r the stock market nor i s i t s impact neutral on share values. I n f l a t i o n has a well-documented pernicious e f f e c t on business f i r m s and t h e i r shareholders. Now i t i s tempting as we view the present s i t u a t i o n , t o hope t h a t we are over the i n f l a t i o n "hump." We have gone from the d o u b l e - d i g i t inflation - 4 - of a few years ago t o r a t e s t h a t c u r r e n t l y r i v a l those of the 1950s and e a r l y 1960s. However, i n my o p i n i o n , i t i s premature t o conclude t h a t prospects f o r increased i n f l a t i o n are nonexistent. In several key respects, the current s i t u a t i o n c l o s e l y resembles t h a t which e x i s t e d i n the l a t e 1960s and which p r e c i p i t a t e d f i f t e e n years of accelerated i n f l a t i o n and d e c l i n i n g stock values. There are two things t h a t we know about i n f l a t i o n . i s p r i m a r i l y a monetary phenomenon. First, inflation While there are a wide v a r i e t y of non- monetary f a c t o r s t h a t influence p r i c e behavior from y e a r - t o - y e a r , these influences e s s e n t i a l l y net out over longer time periods. f o r c e behind i n f l a t i o n i s excessive money growth. The c h i e f d r i v i n g For example, from 1954 t o 1966, money growth was 2.5 percent per year and i n f l a t i o n averaged 2.2 percent per year. From 1967 t o 1982, the money stock grew about 6.4 percent per year and prices rose about 6.5 percent per year. Thus, i f we want t o determine what causes p e r s i s t e n t i n f l a t i o n , we must f i n d out what causes p e r s i s t e n t high growth rates i n money. Second, we know t h a t changes i n money growth have l i t t l e or no immediate a f f e c t on i n f l a t i o n - - m o n e y a f f e c t s i n f l a t i o n w i t h a f a i r l y long lag. Our research a t the Federal Reserve Bank of S t . Louis shows t h a t p e r s i s t e n t changes i n the money stock are followed i n i t i a l l y by changes i n real output. I t takes roughly three years before the f u l l impact of changes i n the money stock show up i n p r i c e s . Thus, while the long-run l i n k between i n f l a t i o n and money growth i s c l o s e , the s h o r t - r u n r e l a t i o n s h i p i s f a i r l y loose and, at t i m e s , tenuous. Accordingly, one should not view the combina- t i o n o f current low rates o f i n f l a t i o n and the 11 percent money growth over the past year as an anomaly. The f u l l impact of t h a t money growth should show up i n 1984 and 1985 p r i c e l e v e l s , not i n the present ones. - 5 - The natural question to ask at this point is what precipitated the acceleration in money growth starting in the late 1960s? Those of us with long memories will recall that, around the middle 1960s, fiscal policy decisions were made which entailed greater expenditure for both domestic and international programs. The rise in expenditures, unaccompanied by higher taxes, produced greater deficits and upward pressure on interest rates. From that time, until late 1979, the Federal Reserve attempted-to "lean against" these interest rate movements. In retrospect, it was more like spitting in the wind. In general, monetary policy is implemented mainly through supplying and withdrawing reserves of depository institutions through open market operations. The changes in reserves produce an expansion or contraction of credit by these institutions. Since interest rates are the price of credit, the net injection of reserves and subsequent increase in the supply of credit, everything else remaining constant, should cause a decline in interest rates. A net withdrawal of reserves, during periods of downward pressure on rates, holding everything else constant, should produce the opposite results. If this line of reasoning is pursued to its logical conclusion, then it appears that the Fed could set some interest rate and hold it there forever by simply supplying or withdrawing reserves in- appropriate amounts. Unfortunately, as our experience since 1965 has shown, there is a fatal flaw in this analysis. remain constant. The flaw is that everything else does not In particular, supplying or withdrawing reserves has predictable effects that produce significant changes in the economy and, not surprisingly, in financial markets as well. When reserves of depository institutions rise, these institutions actively expand their loans and - 6 - investments. In so doing, they also create a d d i t i o n a l checkable d e p o s i t s - - t h a t i s , they create a d d i t i o n a l money. And an increase i n the money supply impacts the economy i n p r e c i s e l y those p r e d i c t a b l e ways t h a t I j u s t detailed. I n i t i a l l y , i t induces an increase i n r e a l economic a c t i v i t y — i n output and employment; u l t i m a t e l y i t produces an increase i n i n f l a t i o n . A decrease i n reserves, o f course, produces opposite and symmetrical changes. These p r e d i c t a b l e r e s u l t s are not missed by bond and stock market participants. I f lenders expect i n f l a t i o n t o a c c e l e r a t e , they w i l l t r y t o p r o t e c t t h e i r purchasing power by demanding higher nominal i n t e r e s t r a t e s . And borrowers, under the same circumstances, w i l l pay the higher r a t e s . Bond and stock prices w i l l d e c l i n e . Thus, prolonged and repeated attempts t o keep short-term i n t e r e s t r a t e s from r i s i n g a c t u a l l y produces, over the longer r u n , accelerating i n f l a t i o n , higher and more v o l a t i l e i n t e r e s t rates and lower share p r i c e s . For example, i n a recovery, when c r e d i t demands are r i s i n g , an attempt t o hold i n t e r e s t rates constant by accelerating reserve and money growth, simply f u e l s the recovery even f u r t h e r . I t generates increased i n f l a t i o n a r y expectations and causes prices and i n t e r e s t rates t o r i s e even higher than otherwise. In an economic c o n t r a c t i o n , attempts t o keep i n t e r e s t rates from f a l l i n g , w i l l produce an even deeper c o n t r a c t i o n and eventually a drop i n interest rates. In other words, attempts t o use monetary p o l i c y t o s t a b i l i z e s h o r t - r u n i n t e r e s t rates produce, i n the long r u n , imstable p r i c e s , unstable employment, and unstable long-run i n t e r e s t rates and lower r e a l stock values—precisely the p a t t e r n we have observed, at considerable expense, unti1 recently. Why i s t h i s past h i s t o r y r e l e v a n t today? Because we face v i r t u a l l y the same pressures now t h a t we faced f i f t e e n years ago. Today we have large - 7 government deficits, both current and projected. Today, although interest rates have currently retreated from the recent peaks, we face projections of higher rates for next year. And, each time interest rates tick upwards, we see increased political and financial market pressure on the Fed to control these rates, to keep them from rising by accelerating credit and money growth. Virtually everyone wants stable interest rates and rising real stock values. You and I, the financial markets, politicians and monetary authorities all do. It is precisely this desire that mistakenly underlies the demands that the Fed should stabilize rates. But, attempting to stabilize the Fed funds rate has a cost: it produces increased fluctuations in long-term rates, accelerations in inflation and reductions in the wealth of shareholders. It has produced fifteen years of real stock market losses. Should monetary policy attempt to directly stabilize short-term interest rates or to indirectly stabilize long-term rates by directly focusing on longer-term money growth? Where do the greater costs lie? I hope that you will agree with me that the problems posed by daily fluctuations in short-term rates are inconsequential compared to the risks facing stock markets produced by volatile and uncertain rates of inflation. Thus, I would like to see a monetary policy that does not try to prevent every market-induced wiggle in interest rates, but which tries to reduce both the level and volatility of inflation. Of course, pursuing such anti-inflationary policy actions is easier to advocate than to actually accomplish. That is evident in the experience of the last three years. And, clearly, there are difficulties in engineering a - 8 - smooth reduction o f i n f l a t i o n . One of the major problems would be maintain- ing such a p o l i c y long enough t o wring out i n f l a t i o n a r y expectations. But we know t h a t there i s very l i t t l e we can do about i n f l a t i o n i n the short r u n . A decline i n reserve growth w i l l , under most circumstances, r a i s e short-term interest rates. Tnis i n v a r i a b l y produces widespread concerns over the p o s s i b i l i t y of inducing a recession. Yet we know t h a t short-term i n t e r e s t r a t e s have l i t t l e impact on the economy. t h a t produce appreciable changes. I t i s the long-term rates We can p r e d i c t with reasonable accuracy what a reduction i n reserves w i l l do t o the money supply. how t o t a l spending w i l l r e a c t . We can p r e d i c t And we have r e l i a b l e estimates of what can happen t o output and what e v e n t u a l l y w i l l happen t o i n f l a t i o n . The longer run problem i s one o f p o l i t i c a l w i l l ; i n the past, long-run p o l i c y actions t o reduce i n f l a t i o n have been repeatedly thrown o f f course by immediate p o l i t i c a l and f i n a n c i a l market concerns about changes i n s h o r t - r u n i n t e r e s t rates. What options do we have? short-term i n t e r e s t r a t e s . We can continue t o demand s t a b i l i z a t i o n of But then we ought t o remember t h a t chances f o r r e a c c e l e r a t i o n o f i n f l a t i o n or appearance of recession increase substantially. Neither of which would bode w e l l f o r the stock market. I , f o r one, prefer long-term i n t e r e s t r a t e s t a b i l i t y and r i s i n g r e a l stock values. This can be achieved only through stable money growth and lower i n f l a t i o n . While we may debate endlessly the d e f i n i t i o n of money and what happens t o v e l o c i t y , even an e l u s i v e monetary t a r g e t i s preferable t o attempted s t a b i l i z a t i o n o f short-term i n t e r e s t r a t e s . In summary, i f we want t o have stock markets t h a t are e f f i c i e n t , t h a t perform t h e i r f u n c t i o n o f channelling savings i n t o long-term investments, and t h a t increase the wealth of shareholders over t i m e , we must maintain low - 9 - and stable r a t e s of i n f l a t i o n . And t h a t cannot be achieved by a monetary p o l i c y t h a t reacts t o e\/ery wiggle of the federal funds r a t e ! Yet, t o my dismay, f i n a n c i a l market p a r t i c i p a n t s are often the ones who clamor the loudest f o r t h i s unsound course. That, perhaps, i s the biggest puzzle of all. Our present s i t u a t i o n appears t o be an o p p o r t u n i t y t o accomplish everyone's desired o b j e c t i v e - s u s t a i n e d economic expansion without undue inflation. The economy i s doing w e l l , i n f l a t i o n i s subdued, and the monetary aggregates are squarely w i t h i n the long-term p o l i c y bands set by the Federal Open Market Committee. In my o p i n i o n , the best way t o keep them there i s t o concentrate on management of reserve growth-- not the l e v e l of short-term i n t e r e s t r a t e s - - s i n c e , over t i m e , t h i s w i l l determine money supply growth. This i s a two-way s t r e e t . I f money growth lags f o r too l o n g , we could p r e c i p i t a t e a recession. As I review the changes i n the p r i n c i p a l monetary aggregates, I note t h a t t h e i r r a t e of growth has slackened i n each successive month since May. However, I also note t h a t growth of the monetary base has picked up considerably since i t s low p o i n t i n J u l y . This leads me t o conclude t h a t growth o f the monetary aggregates w i l l increase at a more appropriate r a t e i n coming months. I leave i t t o you t o decide what t h i s means f o r i n t e r e s t rates and the stock market. One of the o f f s e t s t o what i s euphemistically termed the " p u b l i c sector discount" t o Federal Reserve Bank Presidents s a l a r i e s i s the f a c t t h a t we d o n ' t have t o p r e d i c t i n t e r e s t rates and stock p r i c e s .
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