Stock markets analysts and investors tend to examine every word that Fed members say because they know that an important determinant of stock prices is monetary policy implemented by Federal Reserve. But how does monetary policy affect stock prices? What is the logic behind this relation?
The logic can simply be expressed by Gordon Growth Model. Let’s firstly summarize the model. According to Gordon Growth Model, it is assumed that dividends grow at a constant rate forever, and the growth rate is less than the required return on equity.
Gordon Growth Model:
Current price of stock = Dividend / (required return – expected dividend growth rate)
According to the model, monetary policy can affect stock prices in two ways. First, when the Fed lowers interest rates, the the return on bonds -an alternative investment to stocks- declines, and investors are likely to accept a lower required rate of return on an investment in equity. The resulting decline in rate of return would lower the denominator in the Gordon Growth Model, lead to a higher value of current price of stock, and increase the stock prices.
Second, a lowering of interest rates is likely to stimulate the growth rate of economy, and this will lead to increase in company earnings. The resulting increase in earnings would increase growth rate in dividends. As a result, increasing dividends also leads to a higher value of current stock prices.
By understanding this relation, we can catch the magic of Janet Yellen’s words.