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Another mandate for the Fed?

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Cullen – I know I keep bothering you with questions prompted by Wall Street Journal op-ed pieces – but I hope you take all that as a compliment. As I’m sure you recall, after reading your blog for so many years, I often notice when “experts” in the WSJ or elsewhere reveal one or more misunderstandings about how the U.S. monetary system works. Today, Martin Feldstein’s piece (“New Priorities for a New Fed Regime”) suggests that “financial stability” must become one of the leading objectives of monetary policy. He describes how Fed policies over the past several years (that we’ve all read about many times) that have pushed up share prices (S&P 500), the risk to the economy if the P/E ratio declines to its historical average, he mentions the risks to bond holders (suggesting that with inflation at “around 2%, the long-term 10-year yield should be at about 4.5%), that commercial real estate is overpriced “because investors compare the yield on real estate with the interest rate on long-term bonds”, and finally – the “combination of overpriced real estate and equities has left the financial sector fragile and has put the entire economy at risk.”

What I found most curious about his piece was that he made no attempt to describe how the Fed would carry out its new objective, from this point forward – in this current fragile environment. Put another way, he gave no clues as to what transmission mechanisms the Fed would utilize to achieve “financial stability”.

Perhaps he thinks the new Fed regime can pull off a flat stock market for while (long enough to let the P/E ratios get back to normal), long enough to get the 10-year Treasury yield back to 4.5% (never mind that the 10-year Treasury is an intermediate bond, not a long-term bond), while keeping unemployment low, inflation (which seems to be hiding still) under control, and real estate prices stable.

As the saying goes, “inquiring minds want to know”, so I emailed professor Feldstein at Harvard just about 40 minutes ago. Low and behold – he responded within about 2 minutes! Disappointingly – he didn’t answer my question, where I asked him “to describe…from an operational standpoint, just how the Fed can hope to address the fragility our entire economy faces.”

Here was his answer: “As I explained in the article, the Fed’s extremely easy monetary policy for the past decade contributed to asset overvaluation and therefore to the risks of financial instability.”

Me, sometimes being sort of a pest, responded promptly and pointed out that he described what happened in the past, but not how the Fed would carry out its new objective. I went on to say “Inflation remains low, wage growth has remained surprisingly low given our low unemployment rate (understanding that much of the decline in the unemployment rate could be due to falling labor participation), and loan growth rates – in virtually all categories – are trending down or flat. It seems to me that there’s not enough heat in the economy for the Fed to justify raising interest rates much, but perhaps you have other specific ideas. That gets back to my original question. What levers would the Fed pull to increase financial stability in this environment?”

If Mr. Feldstein responds, I’ll pass along his wisdom. Fun stuff!

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Posted by (Questions: 21, Responses: 60)
Posted on 11/30/2017 5:22 PM
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Hi Steve,

I love your WSJ citations. It often gives me a good idea for an article to debunk. 🙂

I honestly don’t know what Feldstein is getting at. There’s just so many problems with the idea that the Fed is causing the stock market boom:

1) Can anyone prove that rates would be lower than they are if the Fed wasn’t involved? I see nothing to support that. Inflation is low and short-term private bond rates are also low. If the Fed was a private clearinghouse would the private clearinghouse have lower overnight rates? There’s no evidence to support that.

2) How does this theory explain the fact that corporate profits are at record highs and EPS are as well? Did the Fed cause that?

Why can’t people just accept the reality that the stock market is booming because corporate America is booming? Or how about the fact that corporate profits as a share of GDP are at record levels? You don’t need conspiracy theories about “easy money” to explain this stuff. I guess Fed policy has some impact, but it’s crazy to argue that the Fed caused the stock market boom and that it’s all fake.

That said, I actually do believe that the Fed should try to temper market manias. But we also know that the Fed isn’t very good at that. For instance, in 1995 Alan Greenspan started saying the stock market was too high and he started raising rates and engaging in open mouth policy. It did nothing. The market just got crazier. Same thing happened in 2004. The Fed tried to put the brakes on the housing boom, but prices continued to soar despite their actions.

Lastly, I’d point out that Feldstein seems to have an unusually bad understanding of how the Fed actually works and how banking works. He has been worried about high inflation and reserves flooding into bank loans for as long as I can remember. He’s like the engineer who thinks that wishful thinking will make a plane fly. It’s just not operationally consistent with how flight actually works!

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Cullen Roche Posted by (Questions: 10, Responses: 1800)
Answered on 11/30/2017 6:30 PM
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Thanks Cullen. Professor Feldstein hasn’t replied back to me yet (and surely has better things to do). I may send a letter to the editor about the Feldstein piece. It probably won’t get published – but since they did publish one of my letters last year (which, amusingly, prompted another reader to comment on my letter – which the WSJ published), I may give it a shot.

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Posted by (Questions: 21, Responses: 60)
Answered on 12/01/2017 12:19 PM