“In a speech last Thursday, Governor Jerome Powell expressed some concern that QE “might drive excessive risk-taking or create bubbles in financial assets or housing.” He indicated that the Fed’s staff is closely monitoring valuation metrics in various asset markets.
Regarding the stock market, he said: “By most measures, equity valuations seem to be within a normal range. Whether one looks at trailing or forward price-to-earnings ratios, equity risk premiums, or option prices, there is little basis for arguing that markets show excessive optimism about future returns. Of course, in the equity markets there is always downside risk.” I tend to focus on forward P/Es, which suggest that stocks are neither cheap nor expensive.
As for home prices, Powell said that the Fed’s staff tracks a model that compares them to rents. I tried to duplicate it by dividing the median existing home price by the tenant rent component of the CPI. My results come close to Powell’s statement on this subject: “At the peak of the bubble, house prices were more than 40 percent above their usual relationship to rents, according to one model that the Fed staff follows. At their trough, house prices had fallen about 10 percent below fair valuation. Given the price increases over the past year, they are–by the lights of this one model–moving back into the approximate neighborhood of fair valuation.”
On the other hand, Powell was concerned about excesses in the credit markets. He mentioned Governor Jeremy Stein’s speech on this issue earlier this year. He added, “These concerns have diminished somewhat as rates have risen since mid-May.”
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