The present global plague of asset price inflation — with its origins in Federal Reserve quantitative easing policies and featuring much irrational exuberance — is transitioning into a new phase. Some optimistic commentators suggest a benign and painless end to the plague lies ahead. They cite the skill of the Federal Reserve in “ending QE.” These optimists even suggest that meanwhile, controlled injections of new viruses of asset price inflation by the Japanese and European central banks could have a good outcome, and this justifies the risks of the procedure. None of this optimism is justified by the evidence, nor by the known pathology of asset price inflation.
What Was Popular Then
At the start, the plague was largely limited to commodities and emerging-economy asset markets, as the Obama Fed in 2010–11 drove the dollar downward with its launches of QE1 and QE2. The big speculative stories at the time — that investors chased — were: the Chinese mega credit-fueled boom, perpetual high growth in the emerging market economies compared to long-run stagnation in the advanced economies, and the shrinking long-run availability of key commodities, especially oil. Carry trades in the emerging market and the commodity currencies thrived.
Then, as the Draghi ECB launched its campaign to “save the euro” and Japan PM Abe embarked on his “three-arrow strategy” (QE, public spending, and reform) to bring about economic renaissance, the asset price inflation spread to Japanese equities, European equities, and once weak European “periphery” debt. Alongside, the big stories of US shale gas and Silicon Valley captivated investors. More generally, high yield corporate debt markets attracted massive inflows of funds from global yield-hungry investors.
Not Looking So Good Now
Now the areas of global markets which were infected early are recording steep falls in speculative temperature. These include commodities, emerging market currencies, and commodity currencies. The US dollar has been rebounding as the Abe Bank of Japan explodes yet another QE time-bomb, and speculation is rampant that the Merkel-Draghi ECB will soon announce its own monetary experiment. One can find in previous episodes of global asset price inflation (always with its origin in the Federal Reserve) the same pattern of speculative temperatures falling in some old areas of infection even as they rise in newer areas.
For example in the great asset price inflation of the mid and late 1920s the Berlin stock market bubble burst already in 1927, the Florida real estate bubble burst in the same year, and the US real estate market peaked in the following year — all whilst the US equity market continued to inflate. A strong dollar is frequently a feature of this transitioning process as the Federal Reserve begins to reverse its policies of exceptional ease. Currency losses realized by dollar borrowers outside the US can become at such times an element in an unfolding credit crisis.
The Next Phase Begins
The risks of credit defaults exacerbated by present or future currency falls are now looming large in Russia, Brazil, Turkey, and China. The potential crash in the Chinese currency is one of the less talked about subjects. Yet one only has to consider the massive seemingly permanent capital flight from China — financed so far by huge credit inflows into that country as the world chases high yields there — to realize how dramatic could be the turnaround.
Even so, how can we say that US monetary policy has tightened when the Fed is still pinning short-term rates down at virtually zero, 10-year Treasury yields are at 2.35 percent and the size of the Federal Reserve balance sheet (with the main liability being monetary base) is at 25percent of GDP (compared to a normal level of around 8 percent)? Well, first there has been a tightening — in relative terms — compared to actual monetary prospects in Europe and Japan. And second, the neutral level of nominal long-term interest rates has most likely been falling, meaning that the negative gap between market and neutral long-term rates has narrowed since spring 2013. (That was the Emperor’s new clothes moment, when the Fed’s power to hold 10-year rates down at around 1.5 percent was exposed as non-existent.)
In particular, inflation expectations have been falling, soothed in part by the stronger dollar and the fall in commodity prices. And the huge amount of monetary uncertainty, regarding specifically the final phase of the asset price inflation disease when speculative temperatures drop across the board and recession sets in, curbs perceived investment opportunity. Actual investment opportunity is plausibly shrinking across much of the emerging market world especially in bloated real estate and consumer credit sectors. Low long-term interest rates are a — at first glance — paradoxical symptom of the present asset price inflation and its progression toward the final deadly phase.
Where’s the Inflation?
Why have inflation expectations been falling so late in the US business cycle expansion and after so many years of Fed “money printing”? The answer is partly that money printing so far has been quasi rather than the real thing. High powered money is only high powered (in terms of being the proverbial hot potato which individuals and businesses are anxious to avoid holding in excess) when the zero interest rate on monetary base contrasts with substantially positive nominal interest rates on short-maturity bills. This has not been the case in this cycle.
Goods-and-services price inflation emerges in principle when market rates are below neutral across the maturity spectrum and for an extended period of time. The Fed “achieved” this most likely in the long-maturity markets through 2010–12 but the main influence was on global asset price inflation. In goods and services markets there have been powerful real forces downward on prices resulting from profound shifts in the labor market induced by the distinct nature of present technological change.
Yes, Fed QE has weakened further the defenses of the US against the disease of goods-and-services inflation in the next cycle and beyond. The risks of manipulated rates falling below the neutral level when that eventually rises have increased substantially. But understandably for now long-term interest rate markets and business decision makers are focused on the end phase of the asset price inflation disease in the present cycle rather than what might happen next time round.
