Source: China Macroeconomic Forum (CMF).
Wang Jinbin is Executive Deputy Secretary of the Party Committee of the School of Economics, Renmin University of Chinese, Researcher of the National Academy of Development and Strategy, and a key member of the China Macroeconomic Forum (CMF).
Against the backdrop of a decline in inflation and unemployment in November, the Fed's monetary policy faces a new dilemma: the Fed needs to have both a "soft landing" and a cooling of the US financial market. The tight labor market and the wealth effect of excessively high prices of risk assets constitute the "twin pillars" that support the slow decline in core inflation in the United States, and the inflation control target is far from being achieved. In terms of the choice between a cooling labor market and a cooling of financial markets, the Fed may be more inclined to cool financial markets and release the risk of excessively high asset prices.
On December 13, 2023, the Federal Reserve released its latest monetary policy statement, which basically confirmed that the current policy rate of 5.25%-5.50% is a restrictive interest rate level. In the Summary of Economic Projections, which was released at the same time, the US GDP growth rate for this year was raised to 2.6%, and the federal funds rate was lowered to 5.40%. Markets are already anticipating the end of the current rate hike cycle and are starting to predict when and how much they will cut rates next year.
In November, the CPI of the U.S. economy was 3.1% year-on-year, and the core CPI was 4.0% year-on-year, the year-on-year growth rate of CPI slowed slightly, and the year-on-year growth rate of core CPI was the same as that in October. Meanwhile, the unemployment rate unexpectedly fell to 3.7% in November from 3.9% in October. In November, the U.S. economy showed a trend of declining inflation and unemployment, which greatly increased the Fed's expectations for a "soft landing", but the U.S. CPI in November still showed a trend of falling energy prices and higher service prices. If the Fed wants the still-strong labor market to continue to support consumer spending, it will need to be more tolerant of inflation, adopt a time-for-space monetary policy approach, and expect financial markets to cool down and reduce the wealth effect and housing-related service prices, especially rental prices. If financial markets don't cool down, they need to cool the labor market. In terms of the trade-off between cooling the two markets, the Fed may be more inclined to cool the financial markets, otherwise, the decline in core inflation in the United States will be quite slow.
Looking at the price of risk assets in the U.S. financial market, as of December 17, the U.S. stock market has risen too much this year, with the Dow Jones, Nasdaq and S&P 500 up 12.54%, 41.54% and 22.91%, respectively. This is true from both a valuation perspective and a yield perspective. Figure 1 shows the change in the valuations of the three major U.S. stock indices since 2018. 2020 is a special year for the impact of the epidemic, and we used two sample methods to make a simple comparison. Excluding 2020, the average price-to-earnings (P/E) valuations of the S&P 500, Nasdaq, and Dow Jones from 2018 to 2022 are 22.4x, 31.4x, and 22.3x, respectively, and valuations in 2023 are 10.5%, 34.7%, and 14.6% higher than the average of these 4-year valuations, respectively. If we include the special year of 2020, the valuation of the U.S. stock market in 2020 is obviously overvalued in the dual context of the Fed's uncapped easing stimulus and economic downturn, with the Nasdaq's P/E as high as 66.6 times, the S&P's P/E valuation as high as 37 times, and the Dow Jones as high as 30.2 times. The price-to-earnings (P/E) ratios of the Nasdaq and Dow Jones indices in 2023 are 10.0% and 7.0% higher than the average of these 5-year valuations, respectively, compared to the 2018-2022 average valuations, including 2020, and the S&P 500 is 2.3% lower.
Figure 1: U.S. stock market valuation (P/E, TTM)
Source: WIND. Data for 2023 is as of December 15.
From the perspective of dividend yield, the dividend yield of the US stock market has dropped significantly this year. Figure 2 shows the change in dividend yields of the three major U.S. stock indexes since 2018. Similar to Figure 1, the S&P 500, Nasdaq and Dow Jones indices in 2023 will have dividend yields of 15.9%, 22.3% and 21.5% lower than the four-year average from 2018 to 2022, excluding the 2020 exceptions. Including the 2020 sample, the 2023 S&P 500, Nasdaq, and Dow Jones indices have dividend yields of 13.6%, 19.0%, and 19.2% lower than the 2018-2022 five-year average.
Figure 2: U.S. stock market dividend yield (%)
Source: WIND. Data for 2023 is as of December 15.
Overall, compared to the situation in the past five years, the valuation of US stocks in 2023 is too high, and the dividend yield is declining. The overall reflection in the financial market is the rise in investors' risk appetite, which is also supported by the global VIX (CBOE volatility) index that has fallen by 43.3% so far this year.
From the perspective of housing prices, U.S. housing prices have risen this year. In 2023, under the suppression of high interest rates, the supply and demand of real estate in the United States have contracted, and high interest rates have reduced the demand for real estate, but also significantly reduced the supply of real estate, and the inventory of real estate in the United States is only half of the pre-epidemic level, and the lack of supply has led to the continued rise in housing prices. The S&P Case-Shiller Housing Index showed that the average U.S. home price increased by 3.9% in September 2023 from a year earlier. The average U.S. home price has risen by 6.6% since 2023.
According to the data released by the Federal Reserve in the third quarter of 2023, the net wealth of U.S. households in the third quarter of 2023 increased by $7.33 trillion compared with the fourth quarter of 2022, and the excessive rise in financial asset prices was the main reason. Compared to the second quarter of 2023, the third quarter decreased by $1.31 trillion, of which the value of equity held directly and indirectly decreased by about $1.7 trillion, but the value of real estate increased by $0.5 trillion.
It can be seen that the reason why core inflation in the United States is declining slowly and core inflation is stubborn, which is supported by the tight labor market and the wealth effect in the financial market. The tight labor market and the wealth effect of excessively high prices of risky assets constitute the "twin pillars" that support the slow decline in core inflation in the United States.
Against the backdrop of slow core inflation and low unemployment, the Fed's monetary policy is facing new problems, and the Fed needs to cool down the US financial market both for a "soft landing". In terms of the choice between a cooling labor market and a cooling of financial markets, the Fed may be more inclined to cool financial markets and release the risk of excessively high asset prices.