Asset Inflation Cycles: Modern-Day Form of Inflation
In the last twenty-five years, asset price cycles have become more dominant in business cycle analysis, and in doing so, asset inflation cycles have become the modern-day form of inflation. Their importance has become so critical that they have become an explicit part of monetary policy via its new tool, quantitative purchases, whose primary purpose is to increase asset prices/values. With the Federal Reserve now a key player, do asset price cycles still exhibit similar boom and bust patterns as was the case in the past? Or can monetary policy permanently elevate asset prices above and beyond economic and financial fundamentals?
Asset Price Cycles
Several theories help to explain why asset price cycles have become more significant and more volatile over the past twenty-five years.
First, monetary policymakers changed its operating framework in the mid-to-late 1990s, just before the asset price tech bubble. Policymakers abandoned the money supply and credit anchors and started to track real official interest (i.e., Fed Funds level less consumer price index). That created an informal price-targeting policy regime, which years later became formal and removed a policy framework that responded to financial conditions and imbalances that could trigger future inflation or economic problems. Ever since the change in its framework, policymakers have refused to use official rates to dampen speculative and significant asset price cycles.
Second, in the late 1990s, BLS removed the house price signal (i.e., it stopped surveying owner homes for the rent calculation) from its measure of consumer price inflation. That change further broke the link between real estate and consumer price inflation and changed the correlation between real estate and equity prices to positive from negative. So, real and financial asset price cycles became mutually inclusive, which was the opposite of what was usually the case in previous cycles.
Third, globalization (i.e., the ability to import cheap goods) played a role in the US inflation cycle as it helped dampen goods price inflation. With monetary policy shifted exclusively to reported inflation and less to financial conditions, tame consumer price inflation contributed to investors speculating, and often winning that monetary policy will remain easy regardless of asset inflation.
Asset price cycles do not generate public outcry as general inflation cycles, even though history shows they can be equally destructive and destabilizing. That could be because asset price upswings can generate substantial wealth gains while general inflation penalizes everyone. Yet, policymakers have a mandate for financial stability, so they must stand up against the crowd even if it's politically unpopular.
Asset price imbalances or bubbles are hard to detect in real-time and can last long. Yet, one can gain perspective by comparing current market valuations of real and financial assets to past periods of boom and bust.
During the tech bubble, the market value of the real estate and equities on household balance sheets to nominal GDP spiked to a record 2.5 times, falling back to below two during the bust (see chart). The housing bubble helped fuel a more significant spike in market valuations to roughly three times GDP, and again, history repeated itself, as it often does in finance, with market valuation falling back to below two.
The Fed's QE 1 program helped asset prices recover ground lost during the Great Financial Recession, and QE 2 has pushed asset values to GDP to a new record high. Based on Q4 changes in asset prices and GDP, the ratio is estimated at 3.5, just shy of the record high at the end of 2021. If history were to repeat itself, it would take a 35% to 40% decline in both real estate and equity values to match the fall in the Asset/GDP ratio following the tech and housing bubbles. That is not a forecast but an illustration of how far current valuation have deviated from trend. Liquid assets correct sooner and more sharply than real assets so the equity and real estate declines, if they do occur, would not be proportional.
Can monetary policy permanently increase the nominal values of real and financial assets with its new policy tool (QE)? Monetary policy can make things look better and last longer, and QE has done that. But to permanently increase the earnings power and asset valuations is not something monetary policy can do. Every excessive asset and non-asset price cycle in history eventually broke for one reason or another. The current cycle should be no different.
Policymakers are debating when to reduce official rates because general inflation has slowed. Reducing official rates would be a significant policy mistake because of the price imbalance in the asset markets. Instead, policymakers should comprehensively review their policies because the economy's performance, evident with the strong job and wage gains in January, says the total stance of monetary policy remains too easy. In doing the review policymakers will learn that their new tool of quantitative purchases offsets a significant chunk of their official rate policy. In the current climate, it makes more sense to accelerate the reduction of the Fed's balance sheet than to lower official rates.
Joseph G. CarsonAuthorMore in Author Profile »
Joseph G. Carson, Former Director of Global Economic Research, Alliance Bernstein. Joseph G. Carson joined Alliance Bernstein in 2001. He oversaw the Economic Analysis team for Alliance Bernstein Fixed Income and has primary responsibility for the economic and interest-rate analysis of the US. Previously, Carson was chief economist of the Americas for UBS Warburg, where he was primarily responsible for forecasting the US economy and interest rates. From 1996 to 1999, he was chief US economist at Deutsche Bank. While there, Carson was named to the Institutional Investor All-Star Team for Fixed Income and ranked as one of Best Analysts and Economists by The Global Investor Fixed Income Survey. He began his professional career in 1977 as a staff economist for the chief economist’s office in the US Department of Commerce, where he was designated the department’s representative at the Council on Wage and Price Stability during President Carter’s voluntary wage and price guidelines program. In 1979, Carson joined General Motors as an analyst. He held a variety of roles at GM, including chief forecaster for North America and chief analyst in charge of production recommendations for the Truck Group. From 1981 to 1986, Carson served as vice president and senior economist for the Capital Markets Economics Group at Merrill Lynch. In 1986, he joined Chemical Bank; he later became its chief economist. From 1992 to 1996, Carson served as chief economist at Dean Witter, where he sat on the investment-policy and stock-selection committees. He received his BA and MA from Youngstown State University and did his PhD coursework at George Washington University. Honorary Doctorate Degree, Business Administration Youngstown State University 2016. Location: New York.