Weekly Commentary by Dr. Scott Brown
July 21 – July 25
In her monetary policy testimony to Congress, Federal Reserve Chair Janet Yellen offered no new clues regarding when the central bank will begin raising short-term interest rates. The Fed has been criticized for being “behind the curve” on inflation and for fueling bubbles. Neither criticism is right.
Inflation figures have picked up in recent months. The Consumer Price Index rose at a 2.6% annual rate in the first five months of 2014, a 2.3% pace ex-food & energy. The Fed's official gauge, the PCE Price Index, rose at a 1.9% annual rate, a 1.7% pace ex-food & energy (vs. the Fed’s official goal of 2%).
In the depth of the recession, when the Fed began its extraordinary policy measures, a number of critics said that inflation would soon take off and some even suggested that hyperinflation was “just around the corner.” More sober commentators noted that the huge amount of slack in the economy, especially in the labor market, would keep inflation in check. Nearly six years later, higher inflation has yet to arrive. In her testimony to the Joint Economic Committee last month, Janet Yellen dismissed the recent pickup in the CPI as “noise” and there's good reason to believe that's the case. The Producer Price Report (recently expanded to include services) suggests no significant pipeline pressures. Import price figures show no pressure in raw materials or in finished goods. Wage pressures remain relatively contained.
The inflation mongers dismiss low inflation readings as meaningless — the government either isn't measuring inflation correctly or is purposely distorting the figures. There are a number of empirical issues in how inflation is measured, but the Bureau of Labor Statistics does a remarkably good job. Consider MIT's Billion Price Project, which tracks online retail prices and shows inflation relatively close to the official figures. Note that one's personal inflation rate will vary, depending on what goods and services the individual purchases.
At some point, of course, the Fed will need to begin to normalize monetary policy, but there’s nothing to suggest that the Fed is currently behind the curve on inflation.
The other main criticism of monetary policy is that the Fed is fueling bubbles. From the Monetary Policy Report to Congress:
“With regard to asset valuations, house prices have continued to increase, but, for the most part, these increases have left aggregate price-to-rent ratios within historical norms. Moreover, growth in residential mortgage debt has remained anemic, suggesting that the recent increases are not fueled by excessively aggressive lending conditions. More broadly, aggregate measures of the household debt burden appear reasonable despite recent rapid growth in auto lending and student loans, which has strained some borrowers, particularly those in the lower half of the income distribution.”
“However, signs of risk-taking have increased in some asset classes. Equity valuations of smaller firms as well as social media and biotechnology firms appear to be stretched, with ratios of prices to forward earnings remaining high relative to historical norms. Beyond equities, risk spreads for corporate bonds have narrowed and yields have reached all-time lows. Issuance of speculative-grade corporate bonds and leveraged loans has been very robust, and underwriting standards have loosened. For example, average debt-to-earnings multiples have risen, and the share rated B or below has moved up further for leveraged loans. The Federal Reserve continues to closely monitor developments in the leveraged lending market and, in conjunction with other federal agencies, is working to enhance compliance with previous guidance on issuance, pricing, and underwriting standards.”
So, the Fed definitely sees signs of excess in some areas, but this is not a widespread problem for the financial sector as a whole. Yellen promised that the Fed will continue to monitor the situation closely. Earlier this month, she indicated that the Fed would not use monetary policy as the first line of defense against bubbles, but would instead rely primarily on supervision. Yet, she noted that the Fed's regulatory powers, while having increased since the financial crisis, are not where they need to be. Hence, she didn't rule out a tightening of monetary policy as a tool to restrain financial bubbles if need be. Of course, the track record on this is not very good. Tightening to address a bubble, the Fed risks weakening the economy. The financial crisis demonstrates the problem of not tightening soon enough.
One regularly hears that stock prices are artificially inflated due to the Fed's actions and that the market is bound to correct once the Fed begins to raise short-term rates. Let's consider the logic here. Broadly speaking, there are two ways to value stocks. One is to think of the price as a risk-adjusted discounted stream of future earnings. A lower interest rate means that future earnings are discounted less — hence, a higher stock price (all else equal). As the economy improves, earnings should increase, but higher interest rates mean greater discounting of those earnings. It may not be clear whether the increase in earnings will offset the greater discounting, but risk and uncertainty should decrease as the economy improves. However, note that the shape of the yield curve implies an expected path of interest rates, which should be incorporated into the discounting of future earnings. So, stock market valuations should therefore depend not on whether interest rates rise, but on whether they rise faster or slower than the market currently expects. That's the key question.
The other way to value stocks is the same as the way one values art. That is, what’s the next person willing to pay? Technical analysis, the study of chart patterns, is one way to measure market sentiment. That's beyond my ken, but interest rates are probably right about where they should be.
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