Martin Feldstein
Martin Feldstein, Professor of
Economics at Harvard University and President Emeritus of the National
Bureau of Economic Research, chaired President Ronald Reagan’s Council
of Economic Advisers from 1982 to 1984. In 2006, he was appointed to
President Bush's Foreign Intelligence Advisory Board, and,… read more
CAMBRIDGE
– Although the United States economy is in good shape – with
essentially full employment and an inflation rate close to 2% – a world
of uncertainty makes it worthwhile to consider what could go wrong in
the year ahead. After all, if the US economy runs into serious trouble,
there will be adverse consequences for Europe, Japan, and many other
countries.
Economic
problems could of course originate from international political events.
Russia has been acting dangerously in Eastern and Central Europe.
China’s pursuit of territorial claims in the East and South China Seas,
and its policies in East Asia more generally, is fueling regional
uncertainty. Events in Italy could precipitate a crisis in the eurozone.
But
within the US, the greatest risk is a sharp decline in asset prices,
which would squeeze households and firms, leading to a collapse of
aggregate demand. I am not predicting that this will happen. But
conditions are becoming more dangerous as asset prices rise further and
further from historic norms.
Equity
prices, as measured by the price-earnings ratio of the S&P 500
stocks, are now nearly 60% above their historical average. The price of
the 30-year Treasury bond is so high that it implies a yield of about
2.3%; given current inflation expectations, the yield should be about
twice as high. Commercial real-estate prices have been rising at a 10%
annual pace for the past five years.
These
inflated asset prices reflect the exceptionally easy monetary policy
that has prevailed for almost a decade. In that ultra-low-interest
environment, investors have been reaching for yield by bidding up the
prices of equities and other investment assets. The resulting increase
in household wealth helped to bring about economic recovery; but
overpriced assets are fostering an increasingly risky environment.
To
grasp how risky, consider this: US households now own $21 trillion of
equities, so a 35% decline in equity prices to their historic average
would involve a loss of more than $7.5 trillion. Pension funds and other
equity investors would incur further losses. A return of real long-term
bond yields to their historic level would involve a loss of about 30%
for investors in 30-year bonds and proportionately smaller losses for
investors in shorter-duration bonds. Because commercial real-estate
investments are generally highly leveraged, even relatively small
declines in prices could cause large losses for investors.
The
fall in household wealth would reduce spending and cause a decline in
GDP. A rough rule of thumb implies that every $100 decline in wealth
leads to a $4 decline in household spending. The return of asset prices
to historic levels could therefore imply a decline of $400 billion in
consumer spending, equal to about 2.5% of GDP, which would start a
process of mutually reinforcing declines in incomes and spending leading
to an even greater cumulative impact on GDP.
Because
institutional investors respond to international differences in asset
prices and asset yields, the large declines in US asset prices would be
mirrored by similar declines in asset prices in other developed
countries. Those price declines would reduce incomes and spending in
other countries, with the impact spread globally through reduced imports
and exports.
I
must emphasize that this process of asset-price declines and the
resulting contraction of economic activity is a risk, not a prediction.
It is possible that asset prices will come down gradually, implying a
slowdown rather than a collapse of spending and economic activity.
But
the fear of triggering a rapid decline in asset prices is one of the
key reasons why the US Federal Reserve is reluctant to raise short-term
interest rates more rapidly. The Fed increased the overnight rate by
just 0.25% in December 2015 and is likely to add just another 25 basis
points in December 2016. But that will still leave the federal funds
rate at less than 1%. With the inflation rate close to 2%, the real
federal funds rate would still be negative.
Market
participants are watching the Fed to judge if and when the process of
interest-rate normalization will begin. Historical experience implies
that normalization would raise long-term interest rates by about two
percentage points, precipitating substantial corrections in the prices
of bonds, stocks, and commercial real estate. The Fed is therefore
trying to tamp down expectations concerning future interest-rate levels,
by suggesting that changes in demography and productivity trends imply
lower real rates in the future.
If
the Fed succeeds, the decline in asset prices may be diminished. But
the danger of sharp asset-price declines that precipitate an economic
downturn should not be ignored.
No comments:
Post a Comment