Asset Price Inflation Is The Main Risk

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Jerome Powell’s video message last week confirmed what market participants believed would be the outcome of a comprehensive review of the Fed’s strategies, tools and communications that was launched in November 2018.

Namely, the FOMC has adopted what it refers to as a flexible inflation targeting regime. In the future, the Fed will aim to achieve average annual inflation of 2% over a prescribed period.

In practice, the Fed will now allow inflation to exceed 2% following a period of below-target inflation such as the U.S. experienced for the past several years. This procedure differs from the previous way of targeting inflation, in which bygones are bygones – i.e., it ignores past misses and begins each year anew. As shown below, inflation as measured by the personal consumption deflator has been below the Fed’s 2% target throughout the past decade.

One reason for making the change is that, with the Fed funds rate now close to zero, policymakers are concerned that falling inflation expectations could raise the expected real interest rate. Other things equal, this would result in a tightening financial conditions when the unemployment rate is substantially above full employment.

The second, less anticipated, result of the framework review was a change in the way the Fed will evaluate the labor market. In the past, the Fed’s focus was achieving a level of employment that would not generate inflation. If employment rose above this level, the Fed would preemptively tighten policy to ward off expected rises in wages and overall inflation, a relationship described by the Phillips curve.

The weakening in this relationship likely prompted the new focus on maximizing employment until price pressures emerge. The Fed will consider a wide range of indicators when evaluating the labor market, and labor force participation will become more important.

In the last expansion, a shift of workers back into the labor force resulted in higher labor force participation, more jobs, and higher levels of income. Moreover, an expanded labor force can benefit lower income and disadvantaged populations, a step toward narrowing the wide income disparities in the U.S.

For most investors, the clear message from these changes is the Fed is willing to keep interest rates close to zero for the foreseeable future. Some believe this stance eventually will lead to higher inflation. When that happens, it will force the Fed to normalize interest rates, something it has been hesitant to do over the past decade.

My own take, however, is that low inflation expectations are now well ingrained among investors, and it will be difficult for the Fed to alter this any time soon. Rather, the more immediate risk is the potential for an asset bubble.

This phenomenon first arose in Japan in the late 1980s when record low interest rates and rapid credit expansion fueled a boom in the Japanese stock market and real estate. My book, Global Shocks: An Investment Guide to Turbulent Markets, documents how asset bubbles subsequently proliferated over the next two decades to encompass Southeast Asia, technology, U.S. real estate and other markets.

My conclusion is the prominence of asset bubbles is not an accident. They occur when inflation in goods is low and credit is plentiful.

Fed officials acknowledge that asset bubbles are a problem, but believe they should be handled through bank supervision and regulation. However, policymakers have been reluctant to address whether monetary policy is a contributing factor, because they do not view combating asset bubbles as part of the Fed’s mandate.

Since Alan Greenspan opined about “irrational exuberance” in the mid-1990s, the Fed’s approach has been that it cannot time bubbles. Rather, it should contain the fallout from them by flooding the system with liquidity when they burst.

Yet, this asymmetric behavior – in which the Fed intervenes to prop up markets but is reluctant to warn investors when markets overshoot – has reinforced the perception of an implicit “Fed put.”  This is evident today, as the U.S. stock market has set record highs while the economy is operating well below its potential and unemployment is in the vicinity of 10%.

It remains to be seen whether the Fed’s current stance will produce yet another bubble. However, its willingness to intervene in credit markets indiscriminately to head off potential problems distorts capital markets. Over the long term, these distortions may reduce overall economic efficiency if they enable “zombie” firms to stay afloat.

In the end, the Fed may justify its current actions as being necessary to limit the fallout from the corona-virus pandemic.  However, a comprehensive review of the Fed’s policies should look into the unintended consequences of its actions considering how prevalent asset bubbles have become in the past three decades.

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