Martin Feldstein on Fed policy

In a new WSJ piece, Martin Feldstein calls for higher interest rates. I don’t necessarily disagree with the need for somewhat higher interest rates, although I think we need to be very careful not to tighten policy too much.  But I do disagree with his reasoning:

But controlling inflation isn’t the primary reason for the Fed to keep raising the short-term interest rate. Rather, raising the rate when the economy is strong will give the Fed room to respond to the next economic downturn with a significant reduction.

This is wrong.  Raising interest rates reduces the Wicksellian equilibrium interest rate.  That gives the Fed less room to cut rates in the future.  The Fed does monetary stimulus by cutting rates below the equilibrium rate.  The lower the equilibrium rate, the less room there is to use conventional monetary stimulus.

That downturn is almost surely on its way. The likeliest cause would be a collapse in the high asset prices that have been created by the exceptionally relaxed monetary policy of the past decade.

This is wrong.  Downturns cannot be forecast.  Even if they could, they are not caused by high asset prices; they are caused by tight money.  And the recent high asset prices are not caused by easy money, because money has not been easy over the past decade.

It’s too late to avoid an asset bubble: Equity prices already have risen far above the historical trend. The price/earnings ratio of the S&P 500 is now more than 50% higher than the all-time average, sitting at a level reached only three times in the past century. Commercial real-estate prices also are extremely high by historical standards.

This is wrong—bubbles do not exist.  Past P/E ratios are not very useful in predicting asset prices.  If they were, P/E mutual funds would outperform ordinary funds.  Robert Shiller likes to use P/E ratios, and made some predictions about stock prices in 1996 and 2011.  The predictions did not turn out well.  Real estate prices are skewed by NIMBYism, and unusually low interest rates relative to NGDP growth.

The inevitable return of these asset prices to their historical norms is likely to cause a sharp decline in household wealth and in the rate of investment in commercial real estate. If the P/E ratio returns to its historical average, the fall in share prices will amount to a $9 trillion loss across all U.S. households.

Inevitable? If Martin Feldstein wants me to sign a contract to buy San Francisco property in 5, 10 or 15 years, at “historical norms” plus 10%, I’ll sign tomorrow.  Show me where the dotted line is.  Ditto for stocks.  I’ll buy stocks right now, to be delivered in 10 years, at “historical norms” plus 10%.  Does Feldstein want to sell those assets at that price?  After all, if prices fall to historical norms he’d make a 10% profit. Of course I’m not being serious—if I were in his shoes I wouldn’t want to waste time doing a deal with me; my point is for readers to think more deeply about what stuff is worth.

Large drops in household wealth are usually accompanied by declines in consumer spending equal to about 4% of the wealth drop. That rule of thumb implies that a $9 trillion drop in the value of equities would reduce consumer spending by about 2% of gross domestic product—enough to push the economy into recession. The fall in the value of commercial real estate would add to the decline of demand. And with consumer spending down sharply, businesses would cut back on their investment and hiring.

Drops in wealth do not necessarily cause a drop in spending; it depends on why wealth changes.  The stock market crash of 1987 did not impact consumer spending.  Where the two move together, it’s usually because a third factor such as the business cycle is causing both.  But if the Fed keeps NGDP growing at a steady rate (as in 1987), then an asset price drop is not likely to have much impact on consumer spending.  And even if consumer spending does drop, it’s not likely to push the economy into recession as long as the Fed keeps NGDP growing at a steady rate.  What matters is not consumer spending, it’s aggregate spending.

But significant monetary stimulus would be impossible to achieve if the short-term interest rate remains at the current 1.75%. And there is less room than ever for fiscal stimulus, as annual deficits will exceed $1 trillion by 2020 and federal debt will be greater than 100% of GDP by the end of the decade.

This is half wrong.  As Frederic Mishkin used to point out in his best selling monetary economics textbook, monetary policy remains “highly effective” at near zero interest rates.  However, Feldstein is right about fiscal policy.

That’s why it’s important for the Fed to raise the federal-funds rate to 4% over the next two years, which would allow it to cut the rate by at least three points when the next recession begins. Such a rate reduction might not be enough to prevent a recession within the next two years, but it would maximize the Fed’s positive influence on the economy.

It would be a huge mistake to raise rates so sharply (unless the economy got much stronger than I current expect.)  This might well trigger a severe recession, and in that case the equilibrium interest rate would fall sharply.  The Fed would actually have less room to cuts rates than they do right now, not more.

Feldstein’s views are very popular among conservative economists.  But I’m heartened to see that many younger economists and grad students are increasingly moving toward the market monetarist perspective, as events consistently back our interpretation and discredit the standard conservative view.  We are currently behind, but we’ll win in the long run.

PS.  I can’t even imagine what Feldstein would make of the past 27 years in Australia—they must be about to enter an enormous, humongous, stupendous, monumental, colossal, gigantic, titanic, vast, huge, bigly, Great Great Great Depression.  Check out David Beckworth’s post on house prices and debt in Australia, compared to the US.

HT:  Stephen Kirchner




27 Responses to “Martin Feldstein on Fed policy”

  1. Gravatar of Benjamin Cole Benjamin Cole
    30. July 2018 at 16:09

    Orthodox macroeconomics has ossified. See Feldstein.

    BTW the IMF says it is foreign capital inflows, born of current-account trade deficits, that are ballooning asset values in the US. They also warn darkly of a Hyman Minsky moment.

    Perhaps the Fed will reason that the best way to avoid a Hyman Minsky moment is to create one sooner rather than later.

  2. Gravatar of dtoh dtoh
    30. July 2018 at 16:52

    I used to think Feldstein was somewhat bright. Apparently not. What an idiot.

    Nice post.

  3. Gravatar of Iskander Iskander
    30. July 2018 at 17:45

    I don’t understand the “fall in asset price s causes a recession” meme.
    Has anyone provided a consistent mechanism for this?

    It’s just guilty of reasoning from a price change, or of neglecting general equilibrium effects.

  4. Gravatar of Christian List Christian List
    30. July 2018 at 18:42

    OT (Sorry)

    Don’t show this to Benjamin Cole:

    I would say that the US is much more free-trade than Western Europe with their large VAT taxes. Every VAT tax is almost the same thing as a tariff because it does not apply when you export things, but it applies to your domestic population. In a way you could think of the VAT taxes as tariffs that are taxes on consumers, but relatively good for workers. 

    So the question is: How does Scott likes Benjamin point if he is rephrasing it like Thiel does? (I’m still not buying it though. VAT taxes are “tariffs”??? Really, Peter???)

    What I found interesting:

    At the center of this is the question with China. The US exports something like 100 bn a year to China, we import 475 bn. What’s extraordinary, is that if we had a globalizing world, we would actually expect the reverse to hold: you would expect the US to have trade surpluses with China and current account surpluses because we would expect that there is a higher return in China because it is a faster growing country than the US. This is what it looked, let’s say, in 1900, when Great Britain had a trade surplus of 2 percent and a current account surplus of 4 percent of GDP. And the extra capital was invested in Argentinean railroads or Russian bonds.

    True or not?

  5. Gravatar of Christian List Christian List
    30. July 2018 at 18:48

    @Benjamin Cole

    Perhaps the Fed will reason that the best way to avoid a Hyman Minsky moment is to create one sooner rather than later.

    Also know as the “Burn your house down so it can not burn down”-idea. =)

    (On the other hand consider this: Actually burning a lot of houses down could actually stabilize falling housing prices.)

  6. Gravatar of Gary D Anderson Gary D Anderson
    30. July 2018 at 18:53

    What he is saying is that rates will go to far into the negative in the next recession. Since raising rates won’t stop that how can it be prevented, Scott?

  7. Gravatar of Benjamin Cole Benjamin Cole
    30. July 2018 at 20:22

    Christian List:

    Okay, I will take the bait.

    I never said VAT taxes are tariffs. What I said is that they are export subsidies.

    Here is a synopsis of what really goes on, beyond the textbooks:

    The whole concept of “trade trade” is a hollow as the Hindenberg zeppelin, as just as gassy.

    In Far East nations, such as China and Singapore, there is free land and free capital for exporting industries.

    That is the default Fast East definition of “free trade.”


    No VAT taxes on goods and services exported to the US. Ergo, export industries have all the benefits of government—infrastructure, fire and police, national security, public health, civil courts—but piggyback for free. That is the Teutonic concept of “free trade”

    Dudes: There is no such thing as “free,” “fair” or “foul” global trade.

    There is only trade as manipulated by government and multi-nationals.

    You might try to apply WTO rules to officiate global trade. You also might try to referee the World Cup from the top rows of the stadium, in a very thick fog. Without your glasses on.

    In this context, free trade theory is as useful as a colander in a sinking life raft.

  8. Gravatar of ssumner ssumner
    30. July 2018 at 20:27

    Christian, I saw that Thiel interview. He’s a very bright guy, but economics is not his strong suit.

  9. Gravatar of rayward rayward
    31. July 2018 at 09:02

    Rising home prices have fueled the recovery, largely due to the wealth effect. June home sales were down. I’d worry about falling home prices. No, not because I think home prices should continue to rise (indeed, the opposite, as all the investment in houses comes at the expense of investment in productive capital), but because it’s the gift that keeps on giving. Until it doesn’t. Feldstein worries about bubbles, just as the housing market is likely to turn, a turn that will be self-fulfilling if the Fed continues with its current policy of raising rates. Predictions are hard, especially about the future. Sure, anybody can accurately predict the future in hindsight (that’s the game played by most economists), but it takes insight to have foresight.

  10. Gravatar of Sean Sean
    31. July 2018 at 10:53

    Where can i sign up for buying San francisco housing at historical average price plus 50%?

  11. Gravatar of Jerry Brown Jerry Brown
    31. July 2018 at 11:16

    Well thanks a lot Scott for getting me to think more deeply about what things are worth. Wasted about an hour just trying to figure the value of my house and still have no real answer. Perhaps I could sell it for $300,000. But the house itself would cost at least $600,000 to build now. So what is it worth? I mean if a very well insured maniac got loose in the house with a sledge hammer, his insurance company might have to pay up to $600,000 to fix things. Does that mean the house is worth $600,000? Or is it worth what I could sell it for before that happened? And property values are easy compared to trying to value human injuries and lives. I would think. If I could think anymore deeply about this anymore. What are your thoughts on what determines value?

  12. Gravatar of Doug M Doug M
    31. July 2018 at 12:21

    The old, we need to raise rates so we will have room to lower rates when we need to argument.

    The Fed should be managing rates / money growth to what is appropriate for current conditions and worry about future conditions in the future.

  13. Gravatar of Alex S. Alex S.
    31. July 2018 at 13:10

    It’s interesting that you make r* endogenous to monetary policy itself.

    I can readily see how the anticipation of bad monetary policy could lead r* to fall.

    But I’d also have thought of r* as the market-rate of interest that would prevail in the absence of monetary disturbances, and put it on par with the other long-run equilibrium values u* and y* (the natural rate of unemployment and potential RGDP).

    If monetary policy is neutral in the long-run as is generally assumed in macro is it possible this may not be a valid assumption?

  14. Gravatar of Gabe Newell Gabe Newell
    31. July 2018 at 13:49

    Don’t reason from a predicted price change.

  15. Gravatar of Anon Anon
    31. July 2018 at 15:49

    SS – following on from Alex’s query, by “the Wicksellian equilibrium interest rate”,do you mean the short-to-medium term nominal Wicksellian rate? Or are you saying that there may also be effects on real and/or longer term rates from tighter policy? Thanks

  16. Gravatar of Fred Fred
    31. July 2018 at 16:01

    Alex S.,

    I think Sumner is making a distinction, as is made for instance in the Laubach-Williams papers on the subject, between the short-run and long-run values of r*. The short-run rate can move as a function of monetary policy, particularly anticipated policy, though the long-run, flexible-price r* is surely fixed in the same sense as u* and y*. I think the narrative that some within the Fed have been pushing that overheating might bolster r* (for example, by lifting labor participation) is primarily a long-run argument that runs somewhat counter to this assessment–suggesting the Fed can indirectly impact productivity–though it’s my understanding that Sumner rejects this argument, believing that it promotes destructive, pro-cyclical monetary expansion. I tend to agree.

  17. Gravatar of ssumner ssumner
    31. July 2018 at 20:54

    Jerry, You said:

    “What are your thoughts on what determines value?”

    What you can sell it for.

    Alex, “Monetary disturbances” is vague. I think of it as the rate that leads to on target expected growth in aggregate demand.

    Gabe, That’s right.

    Anon, Both short term and long term equilibrium rates tend to fall during recessions.

    Fred, Yes, I agree that long run real rates are not significantly impacted by monetary policy.

  18. Gravatar of Jeff Jeff
    1. August 2018 at 03:12

    Standard asset-pricing theory says that the price of a financial asset is the present value of the stream of future dividends expected from it. If the interest rate used to discount future dividends in the present value calculation falls while the dividends don’t change, the present value goes up.

    For assets that pay a fixed nominal return, like non-indexed Treasury bonds, the relevant interest rate is the nominal rate, but for indexed debt, equities and real estate, the real interest rate is more appropriate because rents and equity dividends tend to rise with inflation.

    The real interest rate these days is quite a bit lower than it was twenty years ago, so it’s not surprising that PE ratios have gone up. It’s exactly what you would expect from standard theory.

  19. Gravatar of Willy2 Willy2
    1. August 2018 at 04:22

    – Australia is indeed in the 1st stages of something VERY nasty. In the last two weeks some very worrisome data was published. In some suburbs of Sydney prices for dwellings came down by MASSIVE amounts. Some home prices came down by over 15% and some condos came down in price by more than 20% (both over a period of some 12 months.) And a falling AUD/USD won’t help either to aleviate the pain.
    – Australian home prices were at 8 times gross household income and in Sydney home prices were even at 12 times household income and that’s very clearly a bubble. Still not convinced bubbles exist ?
    – Some 60% of australians with a mortgage only pay interest. Those people now will have to start pay Principal as well starting this year.
    – Remember the warning of one Steve Keen ?

  20. Gravatar of Willy2 Willy2
    1. August 2018 at 04:35

    – I agree with Martin Feldstein more than with one S. Sumner. Mr. Sumner has – from time to time – such weird ideas.

  21. Gravatar of Willy2 Willy2
    1. August 2018 at 06:22

    – I have a screenshot of how much houses and “units” have fallen in some suburbs in Sydney in the last 12 months (see one of my posts above)

    House price drop:!AluvxwylJSzygTIhxWx9DM9SxYYe

    Unit/apratment/condo price drop:!AluvxwylJSzygTDTadd6jVWermBx


  22. Gravatar of Brian Donohue Brian Donohue
    1. August 2018 at 07:45

    Excellent post!

    “Rather, raising the rate when the economy is strong will give the Fed room to respond to the next economic downturn with a significant reduction.”

    2006 called. They want their monetary policy back.

  23. Gravatar of ssumner ssumner
    1. August 2018 at 10:26

    Jeff, Good comment.

    Willy2, Back for your annual Aussie bubble prediction? Yes, I recall Australian housing bubble forecasts made back in 2003. Keep making the forecast, eventually you’ll be right.

    Brian, I don’t really have a problem with 2006 monetary policy.

  24. Gravatar of Willy2 Willy2
    1. August 2018 at 22:18

    – Ah. Now that’s what I call progress when even S. sumner is changing its mind (although slightly). Did you read the article and the tables ?
    – Still drinking the “Bubbles don’t exist” KoolAid ? Steve Keen has shown that the growth (!!) of australian credit has been falling since early 2017 and that’s the 1st time after “2008”. People who have read Keen’s work and/or watched Keen’s speeches (think: YouTube) know that this means that the australian economy is already in a (deep ???) recesssion.
    – David Beckworth is completely wrong. He thinks the RBA did a wonderfull job in stabilizing the australian economy after “2008” by “targeting NGDP”. Beckworth is simply barking up the wrong tree. If Beckworth would have followed Keen’s work then he would have known the REAL reason why Australia didn’t have “a recession”. Australia simply BORROWED its way out of a recession and was “bailed out” by the chinese CREDIT expansion. But who cares about such tiny details. right ?
    – Steve Keen also shows why monetary policy is a VERY blunt and ineffective instrument to change the direction of an economy. But that requires knowledge of how the banking system works. Do Mr. Beckworth and Mr. Sumner know how the banking system works ?
    – If one S. Sumner wants to know why the US housing market got “crushed” then he should focus on household income, household spending, demographics, credit expansion by commercial banks. And NOT on “Monetary Policy”. But that would require that he will have to change his minds so dramatically that it would be an acknowledgement that they were focussing on the wrong topics. right ?

  25. Gravatar of David Lloyd-Jones David Lloyd-Jones
    2. August 2018 at 13:31

    Benjamin Cole appears to be exaggerating German exporters’ benefits from hisimagined exemption from Value Added Taxation.

    These companies’ exports are exempt only from the taxation of the value added by the act of selling for export. The values added in the course of manufacture have been paid by the exporter at each stage of manufacture. They are not rebated as they would be in the calculation of any domestic VAT.

    Can I be forgiven for thinking it possible that the free land and capital for Chinese exporters are as imaginary as his VAT exemption?

  26. Gravatar of Bob Murphy Bob Murphy
    2. August 2018 at 13:34

    Scott in the OP wrote: “I don’t necessarily disagree with the need for somewhat higher interest rates, although I think we need to be very careful not to tighten policy too much.”

    Scott, I promise you I’m not accusing you of a contradiction. However, I think it would be helpful if you did a “big picture” post explaining your overall worldview. A newcomer, for example, might read the above sentence and be shocked. It sounds like you are: (a) reasoning from a price change and (b) saying that low interest rates go hand in hand with easier money.

    To reiterate, I know you can explain what you mean and all the nuances–I could probably do a decent job of summarizing your view myself. But in any event, I’m just pointing out that sometimes you sound like a normal economist, while other times you criticize people for making casual remarks that look like things you say in your own posts.

  27. Gravatar of ssumner ssumner
    3. August 2018 at 17:46

    Willy2, Where did I change my mind?

    Bob, I meant that there is a case for the Fed raising its interest rate target next month. Where rates should go over the next few years will depend on the economy.

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