In the most interesting exchange during Janet Yellen's final news conference, CNBC's seemingly flustered Steve Liesman asked Janet Yelen a question which in other times would have led to his loss of FOMC access privileges: "Every day it seems the stock market goes up triple digits on the Dow Jones: is it now, or will it soon become a worry for the central bank that valuations are this high?"
Yellen's response was predictable, colorfully so in fact.
Of course, the stock market has gone up a great deal this year. And we have in recent months characterized the general level of asset valuations as elevated. What that reflects is simply the assessment that looking at price-earnings ratios and comparable metrics for other assets other than equities, we see ratios that are in the high end of historical ranges. And so that's worth pointing out. But economists are not great at knowing what appropriate valuations are, we don't have the terrific record. And the fact that those valuations are high doesn't mean that they're necessarily overvalued.
So I think what we need to and are trying to think through is if there were an adjustment in asset valuations, the stock market, what impact would that have on the economy? And would it provoke financial stability concerns?
Here is the best part from Yellen's response:
... I think when we look at other indicators of financial stability risks, there's nothing flashing red there or possibly even orange. We have a much more resilient, stronger banking system.
Actually, Janet, no you don't, because just one week ago, in the annual report from the Office of Financial Stability - one which as Fed Chair one would certainly hope you had read, and which we discussed at the time - issued a very clear and very explicit warning about the vulnerabilities in the financial system, and which warned that the "increase in already-elevated asset prices and the decrease in risk premiums may leave some markets vulnerable to a large correction," a polite government term synonymous with "crash."
It then noted that "such corrections can trigger financial instability when important holders or intermediaries of the assets employ high degrees of leverage or rely on short-term loans to finance long-term assets." Furthermore, echoing Minsky, the OFR did its best paraphrase of "stability is destabilizing" by noting that "historically low volatility levels reflect calm markets, but could also suggest that the financial system is more fragile and prone to crisis."
The OFR further cautioned that valuations are "high by historical standards. The cyclically adjusted price-to-earnings ratio of the S&P 500 is at its 97th percentile relative to the last 130 years. Other equity valuation metrics that the OFR monitors are also elevated."
Oh, and just to make it very clear how high the finability stability risk is, the OFR was kind enough to color-code the threat. It was, drumroll, in red and orange.
So which is it Janet: "nothing flashing red there or possibly even orange"... or as the OFR explicitly notes, everything flashing red and orange, with the added warning that the "increase in already-elevated asset prices and the decrease in risk premiums may leave some markets vulnerable to a large correction."