Should-Read: Martin Feldstein: New Priorities for a New Fed Regime

Should-Read: A price-earnings ratio of 25 corresponds to an expected long-run real equity return of about 4%/year. Why is this seen as dangerously high? Especially given low real rates of return on other assets, why isn’t this just what is appropriate?: Martin Feldstein: New Priorities for a New Fed Regime: “The Fed has kept the short-term federal-funds interest rate at less than the rate of inflation for nearly a decade…

..exploded its balance sheet…. Low interest rates have caused investors and lenders to reach for yield, pushing up asset prices and making high-risk investments and loans. The most obvious increase in financial risk has been the rapid rise in share prices. The price/earnings ratio of the S&P 500 index rose from an average of 18.5 in the three years before the downturn of 2007 to 25.2 now, an increase of 37%. The current P/E ratio is 63% higher than its historic average and higher than all but three years in the 20th century. If the P/E ratio declines to its historic average, the implied fall would reduce the value of household equities by $9.5 trillion. If every dollar of decline in wealth reduces spending by the historic average of 4 cents, the level of household spending would fall by $475 billion, or more than 2% of gross domestic product….

Bond prices are also out of line with historic experience. With inflation at around 2%, the long-term 10-year Treasury yield should be at about 4.5%. Instead it is only about 2.5%. If the yield on long-term bonds returns to normal historic levels, there will be substantial losses of value for current bondholders. Commercial real estate is overpriced because investors compare the yield on real estate with the interest rate on long-term bonds. Since real estate is often held in highly leveraged investments, falling prices could lead to an even greater decline in the net value of real-estate assets. The combination of overpriced real estate and equities has left the financial sector fragile and has put the entire economy at risk. The Fed has so far chosen not to address this fragility….

The departing Fed chair clearly prefers regulatory and supervisory policies that focus on banks over monetary policy when dealing with the risks of financial instability. Let’s hope her successor disagrees and incorporates financial stability as a key goal of monetary policy.

If I may try to summarize what I take to be Marty’s argument: Eventually asset prices—both equity and bond—will normalize. They may normalize suddenly. That would be a huge destructive shock.

So to prevent a sudden destructive normalization in the future, we should act now to remove any doubt that prices will normalize. We should do so by raising interest rates faster and making it clear that we will raise interest rates to a higher level—no matter what that means for the level of employment and the level of inflation. By removing any doubt that normalization is coming and coming relatively soon, we will greatly reduce the chance of a surprise sudden distractive normalization when people finally realize that this time is, in fact, not different.

I see a big problem here. Marty advocates a régime change: a sharp shift in policy to raise interest rates further and faster and commit to raising interest rates to a higher level, to abandon the current inflation targeting régime for one that seeks to put a ceiling on asset prices to keep them from reaching “bubble” levels. But the the extent financial markets are forward-looking and that such a régime change is credible, it would seem to have the greatest possible chance of bringing hat long run into being today. That would be the crash now that Marty Feldstein fears that the future might bring.

Thus I simply don’t understand how this argument is coherent. You try to avoid a possible future cold by giving the economy the flu now? Why?


Brad DeLong
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