The Fed's Biggest Inflation Problem: Record Surge in Equity Asset Prices
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The Fed finally admits it has an inflation problem. Yet, what is the bigger inflation problem and potentially more destabilizing to the economy as it unwinds? Is it the 40-year high in consumer price inflation, or is it the surge and record valuations of asset prices? Of course, policymakers would say it's consumer price inflation. However, I would argue its asset prices since easy money has fueled a record surge in equity prices, lifting macro valuations far above the dot.com bubble.
Asset inflation has been a dominant feature of business cycles for the past two decades or more. And, over the past two years, helped by an avalanche of liquidity as the Fed doubled its asset balance sheet to $8.5 trillion, the market valuation of domestic equities to nominal GDP (i.e., the Buffett Indicator) has jumped to levels never thought possible. At the end of 2021, the market value of domestic equities to nominal GDP stood at 2.55.
It is worth noting that before the pandemic, the Buffett Indicator hit a record high at the end of 2019, surpassing the peak level of the dot.com bubble. In other words, the Fed's easy money policies that resulted in an over-valuation of equities at the end of 2019 created a mind-boggling extreme over-valuation at the end of 2021.
To put the equity market's valuation in perspective, if equity prices dropped 25% in 2022, or a decline four times bigger than the decline in the S&P 500 to date, that would only bring the Buffet Indicator back to the peak of the dot.com bubble. And a drop of nearly double that scale to bring it to the average of the past two decades.
Before the last two years, history shows several years of negative returns following periods of extreme overvaluation. Yet, the S&P equity index has jumped nearly 50% over the past two years, while the Nasdaq is up over 80%. So instead of correcting in value, the equity market moved into a new orbit of over-valuation.
If there are laws of gravity in finance, the equity market is in for a big hurt. That's because monetary policy is a blunt instrument. As policymakers use traditional and non-traditional monetary policy tools to kill the consumer price inflation cycle, it will hit asset prices hard. Moreover, given the scale of over-valuation, the potential decline in equity prices could rival the "big" ones of years past. So investors should take note: history sometimes repeats itself in the world of finance.
Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.
Joseph G. Carson
AuthorMore 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.