Years of Zero Interest Rates and Implications for Stock Prices

US Federal Reserve Chairman James Powell has said interest rates are likely to stay low for years as the economy fights its way back from the coronavirus pandemic. For decades, the goal of US Federal Reserve was to control inflation. Inflation control has now been de-emphasized, the main goal is now maximizing employment. This is a huge shift. The US Federal Reserve is very powerful and now the Federal Reserve is pushing for full employment and using years of zero interest rates as a tool.

There has been fundamental investment wisdom which “Don’t fight the fed”. You are supposed to line up your investments with Federal Reserve Monetary policy. Buy stocks when interest rates are low and avoid stocks when interest rates are high.

There is and has been an inverse relationship between the stock market’s valuation multiples and interest rates. Ten-year treasury rates have fallen to 0.72%.

The central bank now will allow inflation to float above the Fed’s 2% target for a period of time. The Fed no longer will hike rates in order to head off inflation that historically had come with lower unemployment rates.

Many finance papers and financial sites have a regression analysis of the inverse correlation between interest rates and the price-earnings ratio of the SP500 stock index.

At Financial Wisdom Forum, there are multiple online calculators for different fair price-earnings multiples based upon the ten-year bond interest rate.

The very low-interest rates imply a fair price earnings multiple of 150 to 440. Even if the ten-year interest rates were assumed to be 1.5% then the fair price-earnings multiple is 87 to 107. The lower number is for a formula of a multiple of the average ten-year earnings multiple of the price.

The SP500 has only had the PE Ratio stay above 30 from 1998 to about 2003.