asset prices and monetary policy

Yglesias tweets

Seems like Richard Fisher has been reading @Neil_Irwin without understanding him:
http://www.dallasfed.org/news/speeches/fisher/2014/fs140716.cfm

To get a sense of some of the effects of excess liquidity, you need look no further than Neil Irwin’s front-page, above-the-fold article in the July 8 issue of the New York Times, titled “From Stocks to Farmland, All’s Booming, or Bubbling.” “Welcome to … the Everything Bubble,” it reads. “Around the world, nearly every asset class is expensive by historical standards. Stocks and bonds; emerging markets and advanced economies; urban office towers and Iowa farmland; you name it, and it is trading at prices that are high by historical standards relative to fundamentals.” Irwin’s comments bear heeding, although it may be difficult to disentangle how much these lofty valuations are distorted by the historically low “risk-free” interest rate that underpins all financial asset valuations that we at the Fed have engineered. 

I spoke of this early in January, referencing various indicia of the effects on financial markets of “the intoxicating brew we (at the Fed) have been pouring.” In another speech, in March, I said that “market distortions and acting on bad incentives are becoming more pervasive” and noted that “we must monitor these indicators very carefully so as to ensure that the ghost of ‘irrational exuberance’ does not haunt us again.” Then again in April, in a speech in Hong Kong, I listed the following as possible signs of exuberance getting wilder still: 

The price-to-earnings, or P/E, ratio for stocks was among the highest decile of reported values since 1881;
The market capitalization of U.S. stocks as a fraction of our economic output was at its highest since the record set in 2000;
Margin debt was setting historic highs;
Junk-bond yields were nearing record lows, and the spread between them and investment-grade yields, which were also near record low nominal levels, were ultra-narrow;
Covenant-lite lending was enjoying a dramatic renaissance;
The price of collectibles, always a sign of too much money chasing too few good investments, was arching skyward. 

I concluded then that “the former funds manager in me sees these as yellow lights. The central banker in me is reminded of the mandate to safeguard financial stability.”[1] 

Since then, the valuation of a broad swath of financial assets has become even richer, or perhaps more accurately stated, more careless. It is worrisome, for example, that covenant-lite lending has continued its meteoric revival and has even surpassed its 2007 highs.

Irwin:

But while central banks can set the short-term interest rate, over the long run rates reflect a price that matches savers who want to earn a return on their cash and businesses and governments that wish to invest that savings — whether in new factories or office buildings or infrastructure.

In this sense, high global asset prices could be the result of a world in which there is simply too much savings floating around relative to the desire or ability of businesses and others to invest that savings productively. It is a reassertion of a phenomenon that the former Federal Reserve chairman Ben Bernanke (among others) described a decade ago as a “global savings glut.” 

But to call it that may not get things quite right either. What if the problem is not too much savings, but a shortage of good investment opportunities to deploy that savings? For example, businesses may feel that capital expenditures are unwise because they won’t pay off. 

Mr. Bernanke himself has been wrestling with the possibility that the original framing of a global savings glut got the problem in reverse. “I may have made a mistake in trying to assign a name,” Mr. Bernanke, now at the Brookings Institution, said in an interview. “A glut means more than is wanted. But it doesn’t necessarily arise because people want to save more. It can be because they invest less. 

“It’s entirely possible that if you look at the world, you have slow-growing advanced economies, China cutting back on capital investments, that the rate of return is just going to be low.” 

If this analysis of the world is correct, investors have an unpleasant choice: consign themselves to returns lower than the historical norm, or chase ever more obscure investments that might offer an extra percentage point or two of return.

Robert Shiller

Until the recent crisis, economists were talking up the “great moderation”: economic fluctuations were supposedly becoming milder, and many concluded that economic stabilization policy had reached new heights of effectiveness. As of 2005, just before the onset of the financial crisis, the Harvard econometricians James Stock (now a member of President Barack Obama’s Council of Economic Advisers) and Mark Watson concluded that the advanced economies had become both less volatile and less correlated with each other over the course of the preceding 40 years. 

That conclusion would have to be significantly modified in light of the data recorded since the financial crisis. The economic slowdown in 2009, the worst year of the crisis, was nothing short of catastrophic. 

In fact, we have had only three salient global crises in the last century: 1929-33, 1980-82, and 2007-9. These events appear to be more than just larger versions of the more frequent small fluctuations that we often see, and that Stock and Watson analyzed. But, with only three observations, it is hard to understand these events. 

All seemed to have something to do with speculative price movements that surprised most observers and were never really explained, even years after the fact. They also had something to do with government policymakers’ mistakes. For example, the 1980-82 crisis was triggered by an oil price spike caused by the Iran-Iraq war. But all of them were related to asset-price bubbles that burst, leading to financial collapse. 

Those who warn of grave dangers if speculative price increases are allowed to continue unimpeded are right to do so, even if they cannot prove that there is any cause for concern. The warnings might help prevent the booms that we are now seeing from continuing much longer and becoming more dangerous.