Former Federal Reserve Chairman Ben Bernanke started blogging this week. Insights from the former Fed chair can offer insights into how his handpicked successor will be reacting to the economy. Bernanke's blog can also help us understand the relationship between the economy and the markets.
In his first posts, Bernanke has pointed out that low interest rates should increase the amount of investment in the economy. When a corporation evaluates a potential expansion project or any other investment opportunity, they look at the projected return on investment. When rates are low, almost any project can be justified.
As Bernanke notes, "[A]t a negative (or even zero) interest rate, it would pay to level the Rocky Mountains to save even the small amount of fuel expended by trains and cars that currently must climb steep grades."
From this perspective, low interest rates are the fuel for future economic growth. It takes time to see new projects pay off, but they should deliver returns in time.
New projects should both increase corporate profits and help keep inflation low in the future.
When interest rates are high, only some expansion projects will be funded and it wouldn't make economic sense to level the Rocky Mountains. When rates are low, companies can justify building excess capacity that will increase supply. With rates low around the world, excess capacity is being built everywhere. That will reduce inflationary pressures in the future and low inflation will help keep rates low in the future.
If Bernanke is right, higher corporate profits and low interest rates means that stocks deserve to trade at a premium to their long-term average prices. In this environment, the stock market is undervalued and could remain undervalued for years. Low rates are a problem for savers but could be a boom for stock market investors.
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