Tuesday, August 28, 2007

Bernanke the "academic" and Tobin Q

It seems people (or just me) are frustrated because the Fed has been so slow to cut the federal funds rate. But here's Bernanke's reports from Princeton, and it will help market participants understand his mindset. (Tho the Fed does watch the stock prices of banks!) Here's the title and a blurb.

Should Central Banks Respond to Movements in Asset Prices?

Changes in asset prices should affect monetary policy only to the extent that they affect the central bank’s forecast of inflation. To a first approximation, once the predictive content of asset prices for inflation has been accounted for, there should be no additional response of monetary policy to asset-price fluctuations.


Now Bernanke is a believer in Tobin's q. Tobin's q states this: that if the value of a company's assets, on a stock exchange, are worth more, than the company's assets, they will invest more. For those who like a formula:

Tobin's q=market value/replacement or asset value.

Here's what it means. If I invest in a project, will my stock price go up by more than the investment? Does the market see the value of the investment? It does in casinos, but it doesn't in refineries. So refineries aren't built, but casinos are. (See that's the trouble with ascribing formulas as prescriptive. They are in fact descriptive of events, but academics like a predictive component.)

In the real world, the 14th richest person, Sheldon Adelson, of Las Vegas Sands (LVS 97.61) whose Venetian Macau opened today had this to say interview yesterday with Reuters about his new casino: "You think I'm spending 12 billion dollars because I'm a wild-eyed, blue-skied craps shooter?" In a Bloomberg interview last January he said, "You can't make a better match than bringing casinos to Asians." No mention of Tobin q anywhere in his "textbook" talk.

So I had to use the obvious to make my point. More casinos need to be built to bring in more money for shareholders. Less refineries keep the margins high. Isn't that just good business?

So Bernanke's reluctance to cut could be as simple as an academics input in the basic formula above. If you cut interest rates, it will increase the present value of capital. And that causes Tobin's q to increase. Thus you have to cut, not in response to falling asset prices, but inflation. Unless it's a bank or financial asset, which the Fed at least watches.

So how did falling housing prices not become deflationary? When 2/3 of the CPI component for shelter is made up of "owners equivalent rent!" But that's an academic argument!

That's why those that trade, who want a cut in the fed funds now, are dismissive of all this academic talk. Maybe it's time for the academics to open their eyes, and shut their textbooks!