New evidence on what drives central banks to decide to change rates

CENTRAL banks are supposed to target inflation and in some cases, economic growth or full employment. As the “lender of last resort”, they also have responsibility for safeguarding the financial system. But do they in fact target asset prices as well?

That has been the suspicion from the late 1980s onwards, when the Federal Reserve began cutting interest rates when equity markets wobbled. This approach became known as the “Greenspan put” (Alan Greenspan was the chairman of the Fed from 1987 to 2006, and the put option is a form of insurance against falling prices). The implicit guarantee from central banks became a bit more explicit in the era of quantitative easing (QE)—the creation of new money to buy assets. Central banks hoped that QE would have a “portfolio rebalancing effect”, with investors being forced out of low-yielding government bonds and into corporate debt and equities.

However, the relationship between market movements and central banks may have an even longer history. That is the implication of new research by Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School for the latest Global Investment Returns Yearbook, published by Credit Suisse. They looked at the historical relationship between movements in interest rates and in financial markets, with particular reference to America and Britain.

Unsurprisingly, they found that markets performed much better when rates were falling than when they were rising. Since 1913 (when the Fed was founded) American equities have returned an average of 9.3% a year in real terms during easing cycles, defined as the period between the first cut and the first increase. In contast, real returns during tightening cycles were just 2.3% a year. Government bonds returned 3.6% during easing cycles and 0.3% in tightening ones.

This rule applied in most of the 21 countries covered by the trio’s data, going back to 1900. On average, equities earned 8.4 percentage points more in real terms in the year after a rate cut than in one following an increase. Alternative assets such as houses, art and gold also did better when rates were falling.

Link:  http://www.economist.com/news/finance-and-economics/21692927-new-evidence-what-drives-central-banks-decide-change-rates-slaves?zid=295&ah=0bca374e65f2354d553956ea65f756e0