To see his point, think of a share price as containing two elements. One is its fundamental value. This will certainly fall if interest rates rise unexpectedly, as higher rates mean that future cashflows are discounted more heavily, and because they weaken the economy and so reduce those cashflows.
The other component of the price is a bubble element. And there’s no reason to suppose this will fall as rates rise. If an investor expects a 20-30 per cent return on a share, a quarter-point rise in the return on cash won’t deter him from buying it. In fact, it might even embolden him to do so to the extent that a rise in rates signals that the Federal Reserve is more confident about economic prospects. Professor Gali points out that in rational bubbles, share prices should rise in line with the level of interest rates, which implies that a higher interest rate means a higher rate of price appreciation.
US experience, he says, vindicates his concerns. In work with his colleague Luca Gambetti, he shows that since 1960 the average response of share prices to a rise in interest rates has been to fall in the short-term, but then rise. There are, he says. “protracted episodes in which stock prices increase persistently in response to an exogenous tightening of monetary policy”. For example, in the late 90s the Fed raised the funds rate and yet the tech bubble just got bigger.
Now, this apparently perverse response of share prices to interest rates is only possible if the bubble component of share prices is high relative to the fundamental component; if the bubble portion is small or non-existent, the response of shares to interest rate rises is normal.
So, how big is the bubble element? Perhaps the strongest reason for thinking it is significant is that the cyclically-adjusted price-earnings ratio on the S&P 500, as compiled by Yale University’s Robert Shiller, is well above its long-run average (since 1881). How relevant this is is, however, unclear, as this ratio is not far from its post-1990 average. We can only spot bubbles for certain with hindsight.
You might think this isn’t terribly useful. It does, though, have a clear message. If you believe that equities are over-valued, you should not expect a rate rise, on its own, to burst the bubble. For this to happen, we need something else to occur.
