Interest rates and asset prices

The Reserve Bank of India (RBI) has kept the (real) interest rates at extremely low levels. As we know, prices of many assets, and not just bonds, are inversely related to interest rates. And, the sensitivity can be quite high — more so, if we allow for a rise in financial leverage due to low interest rates. So, prices of many assets are higher in India (and elsewhere) than they would have been otherwise.

It is true that the RBI is concerned if we have considerable irrational exuberance or extremely low sentiment in the asset markets. It is, however, interesting that by and large the revealed preference of the RBI is that if its low interest rate policy leads to high asset prices, then so be it! In fact, there is even some solace for the RBI. If low interest rates in a downturn lead to high asset prices and we have an increase in wealth, that can be useful for giving a boost to consumption demand. This is naturally comforting for the RBI in a downturn.

At this stage, it is useful to provide a perspective on asset pricing. Though factors like sentiment can be important in the short-term, and fundamentals guide asset prices in the long-term, RBI’s interest rate policy too plays an important role. Low interest rates in a downturn tend to push up asset prices (and high interest rates in a boom can lower asset prices).

It is true that in a downturn, we have pessimism and so asset prices tend to be low anyway in which case it can be useful if the RBI lowers interest rates and thereby gives a push to asset prices. However, changes in interest rates in a downturn can be substantial and consequently prices of many assets can rise considerably. So, in practice, asset prices can overshoot as a result of the RBI’s interest rate policy.

It follows that often the RBI’s interest rate policy ends up increasing, and not decreasing, fluctuations in asset prices over an economic cycle. All this is not just the story of RBI’s interest rate policy. It applies to central banks more generally. But why would they do this? The focus of the interest rate policy is usually on maintaining full employment, and low and stable inflation. It is not clear if they always succeed in this mission but their policies can have some side-effects and after-effects. Let me elaborate.

Given that many assets are currently high-priced on the basis of the prevailing low interest rates, historical experience suggests that there can be a change. The future real rates of return on many assets can be, ceteris paribus, low. This looks simple. However, there is an important issue here.

We have uncertainty on the actual path of the RBI’s interest rate policy over time. Moreover, this uncertainty is intertwined with the ongoing uncertainty in the asset markets due to changing sentiment and fundamentals. There is another difficulty. The central bank may need to delay the return to normal and relatively higher interest rates, given the very large and rising public debt. So, the whole journey of the interest rates and asset prices towards normalcy can be very long, arduous, messy, confusing and rough. In this confusion, the price signals from the asset markets can adversely affect real investment and growth of GDP. Moreover, ordinary investors can lose at the hands of the sophisticated investors. This is, in an important sense, a rise in economic inequality.

It is true that central banks communicate regularly. However, much uncertainty still remains. This is not to say that the central banks are not forthcoming in sharing information (though sometimes they do). It is just that the central banks are themselves, going forward, not sure about their policies, and understandably so. This is, a fortiori, true in case of a central bank like the RBI, which is hardly an independent central bank.

The story of the interest rate policy for macroeconomic stability does not end with its side-effect as it increases asset price instability. Now this can, in turn, have an after-effect. In more extreme cases, asset price instability can substantially contribute to macroeconomic instability at a later stage. A classic example is how a bubble in asset prices in the 1980s led to the lost decade (1991-2001) in Japan. Another example is what happened in the US in 2007 after the housing bubble burst.

All this raises an important question. Can policy-makers adopt a different interest rate policy with minimal adverse side-effects and after-effects? Yes. But that is a different story (1).

1. Singh, G., 2020, Covid-19, and the way to avoid a blunt interest rate policy, Ideas for India, June 16.

The writer is visiting faculty, Indian Statistical Institute, Delhi