FRBSF Economic Letters

Economic analysis for a general audience

Kevin J. Lansing


History suggests that extreme run-ups in the cyclically adjusted price-earnings ratio are a signal that the stock market may be overvalued. A simple regression model using a small set of macroeconomic explanatory variables can account for most of the run-up in the CAPE ratio since 2009, offering some justification for its current elevated level. The model predicts a modest decline in the ratio over the next decade. All else being equal, such a decline would imply lower stock returns relative to those in recent years when the ratio was rising.

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Working Papers

The latest in economic research

Kevin J. Lansing

This paper develops a New Keynesian model with a time-varying natural rate of interest (r-star) and a zero lower bound (ZLB) on the nominal interest rate. The representative agent contemplates the possibility of an occasionally binding ZLB that is driven by switching between two local rational expectations equilibria, labeled the "targeted" and "deflation" solutions, respectively. Sustained periods when the real interest rate remains below the central bank's estimate of r-star can induce the agent to place a substantially higher weight on the deflation equilibrium, causing it to occasionally become self-fulfilling. I solve for the time series of stochastic shocks and endogenous forecast rule weights that allow the model to exactly replicate the observed time paths of the U.S. output gap and quarterly inflation since 1988. In model simulations, raising the central bank's inflation target to 4% from 2% can reduce, but not eliminate, the endogenous switches to the deflation equilibrium.

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