Martin Feldstein, the Harvard economist who was chief adviser to Pres. Ronald Reagan, says the Federal Reserve should ignore equity markets in setting interest rates.
“The stock market might decline,”
he said in an interview with MarketWatch. “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.”
One measure of market value,
the Shiller cyclically adjusted price-to-earnings ratio, shows that equities are expensive with historical norms. The current value is 24 times, compared with a long-term median of 16 times.
Feldstein said the Fed needs to maintain credibility with investors and demonstrate that it’s not going to keep a floor under asset values.
“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,” he said.
The S&P 500 this month declined more than 10 percent from its May 2015 record high as oil prices dropped and China's economy showed signs of weakness.
Feldstein said it’s better for the Fed to stick with a plan of raising interest rates gradually to ward off inflation and the possibility of another major asset bubble that bursts. The past two asset bubbles in dot-com stocks and housing burst and triggered recessions.
“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,” he told MarketWatch.
Inflation Outlook
Inflation will become more significant if the unemployment rate falls below its current level of 5 percent, he said. The growth in the
money supply during the period of near-zero percent interest rates and quantitative easing didn’t drive inflation because banks parked cash at the Fed.
“People have said to me, ‘since we’ve had this explosion of money, why didn’t that create inflation?’ Feldstein said. “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.”
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