Major Issues Facing The Fed

See New Priorities for a New Fed Regime: Incoming leadership should make maintaining financial stability one of the central bank’s goals by Martin Feldstein. Excerpt:

"The price/earnings ratio of the S&P 500 index rose from an average of 18.5 in the three years before the downturn of 2007 to 25.2 now, an increase of 37%. The current P/E ratio is 63% higher than its historic average and higher than all but three years in the 20th century.

If the P/E ratio declines to its historic average, the implied fall would reduce the value of household equities by $9.5 trillion. If every dollar of decline in wealth reduces spending by the historic average of 4 cents, the level of household spending would fall by $475 billion, or more than 2% of gross domestic product. The lower equity prices and the decline in household spending would also cause business investment to fall, further reducing economic activity.

Bond prices are also out of line with historic experience. With inflation at around 2%, the long-term 10-year Treasury yield should be at about 4.5%. Instead it is only about 2.5%. If the yield on long-term bonds returns to normal historic levels, there will be substantial losses of value for current bondholders.

Commercial real estate is overpriced because investors compare the yield on real estate with the interest rate on long-term bonds. Since real estate is often held in highly leveraged investments, falling prices could lead to an even greater decline in the net value of real-estate assets.

The combination of overpriced real estate and equities has left the financial sector fragile and has put the entire economy at risk. The Fed has so far chosen not to address this fragility."