Does Monetary Policy Really Impact Stock Prices?

One event that catches attention of the investor community every three months is the monetary policy that is announced by the Indian central bank, the RBI…

…like it did today when the RBI announced its quarterly review for the monetary policy for 2011-12.

Every move the RBI makes, even if it is irrelevant to the long term performance of the Indian economy or financial markets, is dissected and discussed threadbare.

Leave the RBI Governor aside, expert opinions flood the newswires from brokers, analysts, and fund managers. Even the Finance Minister shares the limelight in giving his opinion on the RBI’s policy.

Amidst all this, the RBI Governor is either made a hero or a villain, depending on how well he’s taken care of the market’s expectations.

Now the question is – why is monetary policy such a widely followed event in the investor community? What impact does it have on stock prices?

Let’s try to answer these questions.

But before that, let’s first understand what monetary policy really is.

What’s a monetary policy?
In its very simplest form, monetary policy is the process by which the monetary authority of a country – mostly a central bank like the RBI – controls the supply of money. It does this by targeting the interest rates at which money is borrowed and lent.

The ultimate target of a monetary policy is to promote economic growth and price stability (or inflation).

A typical monetary policy is referred to as either being “expansionary” or “contractionary”.

In effect, a monetary policy is like a lever in the hands of a central bank, which it pulls up or down to increase or reduce interest rates, which thereby impacts the money supply in an economy.

Does monetary policy affect stock prices?
If you get a chance to listen to a business channel after the RBI announces its monetary policy – like it did today – you would be forced to believe that the monetary policy is something on which the future of the Indian economy or its stock markets depend.

Of course, monetary policy impacts stock prices but this is temporary and largely a knee-jerk reaction to the degree of change in interest rate vis-à-vis the expectations.

So the stock prices won’t be impacted if the market is expecting the RBI to raise interest rate by 0.5%, and the RBI does exactly the same.

Instead, stock prices will be impacted when the market is expecting the RBI to raise interest rate by 0.5%, and the RBI does something else – maybe raises rate by only 0.25% or does nothing at all.

So, it’s all about the expectations and how different it is from reality.

Now you may ask – “Doesn’t changes in interest rates impact the economy and thus the stock markets in the long run as well?”

Well, in the long run, interest rate is just one of the many variables that impact stock prices.

Its biggest impact falls on the intrinsic value calculation of a stock.

As we discussed in yesterday’s post on intrinsic value, to value future cash flows using the discounted cash flow method, you must discount them back to their present value.

As higher interest rates make a given future cash flow less valuable in today’s rupees, higher interest rates reduce the intrinsic value of a stock.

Click here to open an excel file that comes as part my ‘Value Investing for Smart People” free course on value investing. This excel contains a sample DCF calculation to arrive at a firm’s intrinsic value.

You can find a simple explanation of DCF in the 7th lesson of the value investing course.

As you can see in the excel file, I’ve marked 2 cells in black colour – the ‘discount rate’, and the ‘intrinsic value’.

The ‘discount rate’ is the average cost of capital for a firm, and is dependent on the cost of borrowings (interest rate) apart from the cost of equity.

A rise in interest rate leads to a rise in the discount rate. And as you check out in the excel, as you increase the discount rate from 10% to say 12%, the intrinsic value decreases from Rs 132,514 to Rs 95,956.

In effect, higher interest rates make future cash flows less valuable in today’s rupees, and thus reduce the intrinsic value of a stock.

The second negative impact of higher interest rate on stocks is that it makes investments other than stocks, such as bonds, more attractive.

For instance, a bond that pays me an annual interest of 10% is always safer than a stock that returns 12% with all the risks attached.

As such, rising interest rate raises the return that I would like to earn from stocks and reduces what I would be willing to pay for them.

Under either of the above interpretations, ‘expectations’ of higher interest rates are bad news for stocks.

Anyways, things move in the reverse direction when the ‘expectations’ are for a fall in interest rates.

So all in all, we have a list of three key factors that should affect stock prices when it comes to their relation with monetary policy and interest rates:

1. Expectations that current or future cash flows will be higher should raise stock prices.
2. Expectations that current or future interest rates will be higher should lower stock prices.
3. Expectations that lead investors to demand a higher risk premium (due to higher discount rate) on stocks should lower stock prices.

What this simply means is that the RBI’s actions should affect stock prices only to the extent that they affect investor expectations about cash flows, interest rates, or the riskiness of stocks.

Every other explanation you hear in the media isn’t relevant and worth your time.