Central bank should not pause due to stock market declines, Harvard economist says
Martin Feldstein thinks talk of a recession is overblown.
WASHINGTON (MarketWatch) — Martin Feldstein, a prominent Harvard
economist once on many people’s short-list to lead the Federal Reserve,
has a simple message for the U.S. central bank: ignore the stock market.
In
an interview with MarketWatch, Feldstein said stocks are overvalued.
Any signal from the U.S. central bank that it may pause from its plans
to continue raising interest rates would only create the impression that
there is a “Fed put” on the market. A put is an option that protects an
investor from losses.
In the interview, Feldstein, now 76 and
the president emeritus of the National Bureau of Economic Research, sees
a risk of higher inflation going forward. He said growing talk of a
recession in the U.S. is misguided.
MarketWatch: In a column in the Wall Street Journal in August,
you said this about Fed policy: “It is time to escape the unprecedented
monetary policy that for a while stimulated demand – but then distorted
prices and brought about the current corrections.” Can you unpack that?
What is going on?
Feldstein: They introduced
unconventional monetary policy, quantitative easing. It was successful
in the way that the Fed and [former chairman] Ben Bernanke predicted, in
that it raised household wealth by driving investors into equities and
increased the value of homes. And in response to that increase in
wealth, consumers went out and spent more and that got the economy
going. I think it was as simple as that, and it was effective. But, at
the same time, these super-low, sustained low interest rates have led to
a variety of risk-taking that could cause significant problems going
forward. So the stock market got pushed up to a point where the
price-to-earnings ratio is about 30% higher than it’s been historically
and we’re seeing what that’s doing in terms of falling equity prices and
similar things are happening on high-risk debt, and I could go on.
MarketWatch: You want them to tighten more?
Feldstein:
I want them to do what the FOMC forecast in December, which is that
they would take the rate up by 100 basis points in 2016 and continue to
do more in 2017. And even that will still be very easy, accommodative,
monetary conditions.
MarketWatch: Won’t financial conditions tighten and the stock market decline?
Feldstein: That’s
right, the stock market might decline. But if the stock market is very
overvalued we shouldn’t be surprised that, at some point, it has to
revert to a more normal level.
MarketWatch: Won’t that damage the economy?
Feldstein: I’d rather it happen slowly, then build up the kind of problems we had in 2006, 2007 and 2008.
MarketWatch: So this is just an adjustment the economy has to make?
Feldstein:
The danger, in my mind anyway, is if the Fed keeps interest rates
extremely low, if they say, in reaction to the recent decline in equity
prices, if they say: “Well maybe we shouldn’t raise interest rates,”
that will just be a signal to buy more equities and to push up the price
of equities even further and to get things further out of line so when
the correction comes, it will be even bigger.
MarketWatch: So asset prices are now overvalued and that has to reverse?
Feldstein: Yes, and making it worse would not be a good thing.
MarketWatch:
You’ve been worried about inflation for some time –even pressing Fed
Chairwoman [Janet] Yellen when she first took office about it. Haven’t
you been wrong so far?
Feldstein: I think I
have said it was important for the Fed to make it clear that they cared
about inflation. I think I wrote that and I said that in the
Economic Club of New York discussion with Janet Yellen
[in April 2014]. I’ve also explained, in a Project Syndicate piece,
that contrary to what a lot of people say, there hasn’t been a big
increase in the money supply, and therefore inflation is unlikely.
People have said to me, ‘since we’ve had this explosion of money, why
didn’t that create inflation?’ And what I wrote that we haven’t had that
explosion of money, what happened was the commercial banks took the
opportunity to just leave funds at the Federal Reserve. They didn’t use
those funds to expand their lending and to expand the money supply. But I
think there is the danger going forward, that, starting where you are
today, with an unemployment rate of 5%, if the Fed continues to have
negative real short-term rates, that we could see the unemployment rate
drifting down below 5% and, at some point, that would start to raise
inflation.
MarketWatch: Larry Summers, and
others, have argued that the neutral interest rate – the level of
interest rates consistent with full employment – is lower now than it
used to be. It sounds like you are not buying that.
Feldstein: Yes,
I am not a big fan of those arguments. I think it is hard to know. What
we know is that actual rates are very low, but we know the Fed has made
that happen. So the neutral real rate is not a number you can see in
the market, it is a number that economists can try to calculate but I am
not persuaded that that number is a negative number or dramatically
lower.
MarketWatch: You want the Fed to hike rates steadily, step-by-step toward something like a 3.5% terminal rate?
Feldstein: Assuming that inflation does increase, as the Fed itself predicts, remember
that core CPI is at 2.1% relative to 12 months ago,
so if someday the price of oil stops falling, we will see actual
inflation catch up with the core, so when the inflation rate gets into
the 1.5%-2% range, then I think normalization of interest rates means
getting interest rates back to, as you say, 3.5% to 4%.
MarketWatch: Do you want them to go steadily, go in March?
Feldstein:
I hate to use their expression but it’s data dependent. So it depends
on what is happening in the economy. But I wouldn’t take the fall in the
equity market as a reason not to stick to their interest rate expansion
path because I think that would send a very bad signal to investors
that there is a kind of Fed put there and that they don’t have to worry
because the stock market only goes up, because that will get it further
out of line with reality.
MarketWatch: There has been growing talk about a recession. You don’t sound so worried.
Feldstein:
I’m not. We’ve had a weak [fourth] quarter, basically we had a very
weak October. We don’t have December numbers yet. If you look at the
various forecasts that you and I probably both look at, for the first
quarter, there are numbers in the 2.5% range for real GDP, so I don’t
see any serious problem. And even the fourth-quarter numbers, which are
just estimates at this point, are primarily driven by reductions in
inventories and weaker exports. So it is not domestic demand that is
doing this.
MarketWatch: If the Fed keep raising rates, won’t the dollar continue to strengthen and hurt manufacturing?
Feldstein:
If we look at the impact of the exchange rate on the cost of imports
and competitiveness on exports, there is very little in it from the
exchange rate. The main thing that has driven the cost of imports has
been the energy price, and the government breaks out those two
components of what drives the import price index. The competition that
supposedly comes from abroad because of the exchange rate is very small
relative to the part of the import price index that is driven by energy.
MarketWatch: So commercial real estate is another example of a bubble?
Feldstein: Overvalued. The number I hear is cap rates of around 3%, that is not sustainable.
MarketWatch: Part of your concern is the Fed doesn’t have good tools to combat asset bubbles.
Feldstein:
They perhaps could have them if they wanted them, but they certainly
don’t use them. They have said that we should have macroprudential
policies other than interest rates as a way of dealing with these kinds
of risks. But when you look around, it is hard to see what those are,
other than building up the capital requirements for commercial banks,
which, in itself is a macroprudential policy, does reduce the risk of
the banks getting into the kind of trouble that they did before. On the
other hand, we have to remember that the banks are just one-third of
total capital raising in the United States.
MarketWatch: It seems you were never a big fan of quantitative easing. You don’t want it in the tool kit for the next downturn?
Feldstein:
I suppose it comes down to what’s the alternative. If you had said to
me before the economic downturn: “What do you think about fiscal policy
as a tool for fighting downturns,” I would say that is not a very good
tool, we have learned from experience that trying to use discretionary
fiscal policy is likely to get us in trouble because we can’t move fast
enough. But when this downturn happened, I felt that this is different
from previous ones. It was deeper and more importantly, longer, and
therefore there was room to do fiscal policy, but the fiscal policy that
the administration did in 2009 was just very badly designed and really
didn’t do much to stimulate demand.
MarketWatch: And that forced the Fed.
Feldstein:
And the Fed came along and said: “Well, if conventional monetary policy
won’t do it, and fiscal policy they tried and failed, so it’s up to us
now.” And I don’t disagree with that.
MarketWatch: What about other tools to combat downturns — negative rates and raising the 2% inflation target to 4% — you are not a fan?
Feldstein: I am not a fan.
MarketWatch: Let’s take those one at a time — negative rates
Feldstein: Negative
rates just provide even more incentive for excessive risk taking.
People saying: “Well I can’t get a decent return on a relatively safe
asset, so I will take duration risk, I will take credit risk, I will
invest in real assets like commercial real estate with exceptionally
high prices.” So I think that is not a good thing. And of course in
Europe, it is not doing much for them.
MarketWatch: And moving the inflation rate higher?
Feldstein:
I am old enough to remember the pain of the inflation in the late 1970s
and the early 1980s before Paul Volcker came around and fixed that
problem. We paid a high price for getting back to a world where people
believe inflation is going to stay low, and if we now come along and
say: “Well instead of 2% , let’s go for 4% or 5% because that has
certain technical advantages,” then people are going to say: “Oops, what
are they going to do next.”
MarketWatch: I
hear what you’re saying but maybe I’m not as sanguine as you are. With
growth around 2%, couldn’t we end up in a ditch if the Fed does too
much?
Feldstein: That’s why, when you asked
would I commit to that or would I see how it plays out, I said I must
see how it plays out. That’s data-dependent movement.
There
had been an eerie silence at the Comex in recent weeks, where after
registered gold tumbled to a record 120K ounces in early December
nothing much had changed, an in fact the total amount of physical
deliverable aka “registered” gold, had stayed practically unchanged at
275K ounces all throughout January.
Reuters
