Martin Feldstein has been warning about the disasters that would befall us thanks to Fed policy for over five years. His November 2, 2010 op-ed piece in the Financial Times (“QE2 is risky and should be limited”) provoked me to write this letter to the editor in response. Feldstein continued assailing QE in 2013 in a May 9 contribution to the Wall Street Journal to which (having become a blogger in 2011) I responded with this post. Stock prices having dropped steeply so far in 2016, Feldstein seems to think now — five years after pronouncing, with the S&P 500 at 1188, stocks overvalued — is a good time for a victory lap.
The sharp fall in share prices last week was a reminder of the vulnerabilities created by years of monetary policy. While chaos in the Chinese stock market may have been the triggering event, it was inevitable that the artificially high prices of U.S. stocks would eventually decline. Even after last week’s market fall, the S&P 500 stock index remains 30% above its historical average. There is no reason to think the correction is finished.
One would like to know by what criterion Feldstein thinks he can discern when stock prices are “artificially high.” Unlike Scott Sumner, I don’t accept the efficient market hypothesis, but I do agree with Scott that it takes a huge dose of chutzpah to claim to know when the entire market is “artificially” high, and an even bigger dose to continue making the claim more or less continuously for over five years even as prices nearly double. And just what does it mean, I wonder, for the S&P 500 index to be 30% above its historical average? Does it mean that PE ratios are 30% above their historical average? Well PE ratios reflect the rates at which expected future profits are discounted. If discount rates are below their historical average, as they surely are, why shouldn’t PE ratios be above their historical average? Well, because Feldstein believes that discount rates are being held down – artificially held down – by Fed policy. That makes high PE ratios are artificially high. Here’s how Feldstein explains it:
The overpriced share values are a direct result of the Federal Reserve’s quantitative easing (QE) policy. Beginning in November 2008 and running through October 2014, the Fed combined massive bond purchases with a commitment to keep short-term interest rates low as a way to hold down long-term interest rates. Chairman Ben Bernanke explained on several occasions that the Fed’s actions were intended to drive up asset prices, thereby increasing household wealth and consumer spending.
The strategy worked well. Share prices jumped 30% in 2013 alone and house prices rose 13% in that year. The resulting rise in wealth increased consumer spending, leading to higher GDP and lower unemployment.
I have to pause here to note that Feldstein is now actually changing his story a bit from the one he used to tell, because in his 2013 Wall Street Journal piece he said this about how well Bernanke’s strategy of holding down interest rates was working.
But despite the Fed’s current purchases of $85 billion a month and an accumulation of more than $2 trillion of long-term assets, the economy is limping along with per capita gross domestic product rising at less than 1% a year. Although it is impossible to know what would happen without the central bank’s asset purchases, the data imply that very little increase in GDP can be attributed to the so-called portfolio-balance effect of the Fed’s actions.
Even if all of the rise in the value of household equities since quantitative easing began could be attributed to the Fed policy, the implied increase in consumer spending would be quite small. According to the Federal Reserve’s Flow of Funds data, the total value of household stocks and mutual funds rose by $3.6 trillion between the end of 2009 and the end of 2012. Since past experience implies that each dollar of increased wealth raises consumer spending by about four cents, the $3.6 trillion rise in the value of equities would raise the level of consumer spending by about $144 billion over three years, equivalent to an annual increase of $48 billion or 0.3% of nominal GDP.
So in 2013, Feldstein dismissed the possibility that the increase in stock prices had had a significant effect on consumer spending. In my 2013 blog post responding to Feldstein, I noted his failure to understand the sophisticated rationale for QE as opposed to the simplistic one that he (and, in fairness, Bernanke himself) attributed to it.
[A]ll that is irrelevant, because the portfolio balance rationale for QE misrepresents the mechanism whereby QE can have any effect. That mechanism is primarily by preventing inflation expectations from dropping. Each one of the QE episodes has been initiated when expectations of inflation were dropping. In each instance, the announcement or even the expectation of QE succeeded in reversing the downward drift of inflation expectations, thereby contributing to expectations of increased profits and cash flows and thus allowing stock prices to recover from their deeply depressed levels after the 2007-09 downturn and panic.
But now Feldstein says that QE really was effective, even though in 2013 he dismissed as inconsequential the mechanism by which QE could have been effective, failing to acknowledge that there was an alternative mechanism by which QE might work. Nevertheless, in today’s op-ed, Feldstein confirms that he still believes that the only way QE can be effective is via the discredited portfolio-balance mechanism.
But excessively low interest rates have caused investors and lenders, in their reach for yield, to accept excessive risks in equities and fixed-income securities, in commercial real estate, and in the overall quality of loans. There is no doubt that many assets are overpriced, and as the Fed normalizes interest rates these prices will fall. It is difficult to know if this will cause widespread financial and economic declines like those seen in 2008. But the persistence of very low interest rates contributes to that systemic risk and to the possibility of economic instability.
Unfortunately, the recently released minutes of December’s Federal Open Market Committee meeting made no mention of financial-industry risks caused by persistent low interest rates for years to come. There was also no suggestion that the Fed might raise interest rates more rapidly to put a damper on the reach for yield that has led to mispriced assets. Instead the FOMC stressed that the federal-funds rate will creep up very slowly and remain below its equilibrium value even after the economy has achieved full employment and the Fed’s target rate of inflation.
Simply asserting that interest rates are “excessively low” is just question begging. What evidence is there that interest rates are excessively low? Interest rates for Treasuries at maturities of two years or more are lower today, after the Fed raised rates in December than they were for much of 2015. Under the Feldstein view of the world, the Fed had been holding down interest rates before December, so why are they lower now than they were before the Fed stopped suppressing them? The answer of course is that the Fed controls only one interest rate in a very narrow sliver of the entire market economy. Interest rates are embedded in a huge, complex and interconnected array of prices for real capital assets, and financial instruments. The structure of all those prices embodies and reflects the entire spectrum of interest rates affecting the economy. It is simply delusional to believe that the Fed can have more than a marginal effect on interest rates, except insofar as it can affect expectations about future prices – about the future value of the dollar. In the absence of evidence that the Fed is affecting inflation expectations, it is a blatant and demonstrable fallacy to maintain that the Fed is forcing interest rates to deviate from equilibrium values that would, but for Fed intervention, otherwise obtain. No doubt, there are indeed many assets that are overpriced, but, for all Professor Feldstein knows, there are just as many that are underpriced.
So Professor Feldstein might really want to take to heart a salutary maxim of Ludwig Wittgenstein: Whereof one cannot speak, thereof one must be silent.