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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