What Do Interest Rates Reveal About the Stock Market? A Noisy Rational Expectations Model of Stock and Bond Markets

Abstract

We propose a novel theory and provide supporting empirical evidence that lower long-term interest rates (e.g., because of "quantitative easing") harm informational and allocative efficiency. We develop a noisy rational expectations equilibrium model with an endogenous interest rate that investors use to update their beliefs about economic fundamentals. The interest rate reveals information about discount rates, allowing investors to extract more information about cashflows from stock prices. The precision of the interest-rate signal and, hence, stock-price informativeness increase in the interest rate. As a result, informational and allocative efficiency rise with bond and money supplies and with policy transparency.

Keywords: (endogenous) interest rates, informational efficiency, capital allocation efficiency, rational expectations, unconventional monetary policy

JEL Classification: E43, E44, G11, G14