Asset Inflation: The Missing Indicator In Economic And Monetary Policy

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Although statements have been made by some Federal Reserve officials such as Kevin Warsh and Thomas Hoenig that interest rates will have to rise sooner and faster than the market expects, the Fed continues to reiterate that "economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

High unemployment and concerns about deflation are holding the Fed back from raising rates from nearly zero percent. Going by the Fed’s favored measurements of inflation that exclude or give less weight to all the products and services consumers need to survive, it will be some time before the Fed acknowledges that inflation exists and must be tamed with tighter monetary policy.

One key indicator of inflation that economists as well as Ben Bernanke and his predecessor Alan Greenspan refused to acknowledge is asset inflation. Nearly zero interest rates “for an extended period” are creating asset inflation as investors seek higher returns from stocks, commodities, and the Treasury market.

Greenspan continues to warn that the government should not over regulate financial markets since a major financial crisis only comes along “once every hundred years.” Beyond the Maestro’s memory lapses (1997 Asian crisis, 1998 LTCM, 2000 tech wreck, and the 2007-08 credit and housing bubbles we’re still mopping up), highlights the importance of factoring asset inflation into monetary policy. Greenspan believes if bank capital requirements included long tail events, the banks would not be profitable enough in good times.

Economists and Fed officials would no doubt claim it is impossible to measure what part of asset prices are truly inflated versus real increased worth. But dissecting asset inflation versus real growth is not that difficult.

Looking at the stock market, if certain individual stocks increase in value while the remaining stocks do not, those individual stocks might be moving higher based on fundamental factors such as sales growth. If the entire market is rising in unison, than either economic fundamentals must be strong (low unemployment, etc.) or a bubble is forming. The latter reflects the presence of inflation in the stock market.

Commodity prices, particularly in precious metals and crude oil, are also exhibiting asset inflation. When you strip out current and short term industrial needs, you are left with inflation. Demand for gold jewelry is way down, yet gold topped $1,055 this week. According to the IEA, OPEC is producing 1.6 million barrels a day above their 24.845 million barrels a day. And oil trading companies, refineries, and banks such as Goldman Sachs (GS) are paying to store vast amounts of crude oil in offshore tankers. While crude prices have dropped from their mid-2008 peak, oil prices hovering in the $65-75 a barrel range does not reflect the utility demand relative to supply. Treasuries are behaving very much like commodities and precious metals; all three are gold alternatives.

It would not have been difficult to calculate the high level of asset inflation present during the housing bubble either. Yet as a member of the Fed Board of Governors at the time, Bernanke believed that improving economic fundamentals were behind the rapid increases in home prices throughout the nation.

If a handful of homes in a neighborhood are selling at higher prices because the sellers have added value in some way, or certain external dynamics (for instance, more employment opportunities in the area) increased the value of an entire neighborhood, then property values are increasing due to fundamental factors. But during the boom years virtually every home, neighborhood, city, state – in essence the entire nation’s house prices - rapidly increased in value. Condition was not even a factor.

If the Fed factored in asset inflation in setting monetary policy, Greenspan could have never kept interest rates at 1% for so long. Nor could he have so slowly raised rates a measly 25 basis points at a time.

The current Fed feels monetary policy can remain overly accommodative until the velocity of money increases because their measure of inflation does not include asset bubbles. But the danger is that money velocity can change far more rapidly than the Fed can withdraw liquidity from the currency supply. The world has already lost confidence in our “strong dollar policy” so that when the export dominated countries realize that our consumer economy will never return to what it was, they will stop supporting our currency. This will reduce consumer spending recycled into treasuries from China and friends leading to the real collapse in the dollar.

Hopefully the world will force our stubborn and arrogant Fed to act responsibly.

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1 comment:

Anonymous said...

Ms. Deborah,

Ive been following your reports regularly for quite some time and would like to let you know how much your perspectives are appreciated. Thank you and please keep up the good work!