Must-read: Why low rates lead to capital misallocation



Capital is being misallocated. Finally, unconventional monetary policy of recent years has encouraged significant bouts of capital misallocation, resulting in crowded trades, correlated risks and the overly stretched valuations seen in markets today. These in turn, are increasing systemic risk, raising the potential for a violent capital unwinding.

Shiller PE sp 500

Market Realist – The Shiller price-to-earnings ratios for the S&P 500 are elevated, as you can see in the graph above.

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The cyclically adjusted price-to-earnings ratio or CAPE—also called Shiller’s PE ratio—is a valuation metric that usually applies to broad equity market indices such as the S&P 500 (SPY) and the Dow Jones industrial average index (DIA). It’s a modification of the price-to-earnings ratio. Robert Shiller, the developer of the CAPE, defined it as the price of a stock divided by the ten-year moving average of its earnings. The high Shiller PE ratios you can see in the graph above point to concerns about stretched valuations of the S&P 500 index.

Both small caps (IWM) and biotechnology (IBB) stocks have been considered overvalued in 2014. According to Bloomberg estimates, the Russell 2000 index (IWM) had a price-to-earnings multiple of 49x in March 2014 while the S&P 500 (IVV) had price-to-earnings multiples of 17.2x in March 2014.

To be sure, despite the Fed’s recent rate projection revisions, interest rates are still likely to remain historically low for the foreseeable future. That said, I welcome signs that the Fed may be anticipating a need to raise rates sooner than previously expected, opening the door to merely “easy” monetary policy from “excessively easy” policy.

Given the five unintended consequences I highlight above, I’ve grown skeptical of the usefulness of excessively low policy rate levels, which may now be harmful to the U.S. economy and labor market. The utility of the Fed’s zero interest rate policy is now exceeded by the costs, similar to what happened to quantitative easing before it.

The bottom line: As I’ve mentioned before, select fiscal initiatives (like training to help address the job opening-worker skill mismatch) would be significantly more beneficial to the economy and labor market than continuing overly-easy interest rate policy.

Market Realist – Read our series Kocherlakota—real rates must be kept low over the next five years to learn more about how low interest rates can affect markets.


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