The conundrum facing the Fed is what to do about soaring asset prices when wage and consumer price inflation remain relatively dormant.
The Fed has little choice but to pay increasing attention to asset prices in its deliberations. For in the end, trees do not grow to the sky. Capitalism does not operate that way. Inflationary pressures today are firmly embedded in the prices of financial assets. The longer an asset price bubble persists, the more severe the costs of unwinding it are likely to be.
While traditional sources of inflation have remained dormant, financial liberalization and technological advances have introduced asset price bubbles financed by an enormous expansion of credit and liquidity.
With the exception of three quarters of recession in 1990-'91, the U.S. economy has enjoyed 16 years of uninterrupted economic growth. Yet, to the surprise of investors and the Federal Reserve board of governors alike, consumer price and wage cost pressures remain quite subdued and are not expected to interrupt growth.
Rather, the potential for a sharp decline in U.S. equity prices represents the primary threat to the current expansion. A number of factors -- including a decline in business profitability, a rise in interest rates, a slowdown in economic growth, or a contraction in credit -- could trigger a dramatic drop in equity prices. It is here that the seeds for the next recession are incubating.
Significant structural changes (e.g., globalization, technological advances and financial liberalization) in recent years have reshaped economic cycles, permitting expansions to continue for longer periods with modest inflation. These developments have heightened global competition, tempered inflationary pressures and immunized businesses from impediments (e.g., rising inventories) that in the past have triggered recessions.
Global pools of liquidity today permit investors to discipline governments that do not implement "market friendly" macroeconomic policies. When government policies move out of line with market expectations, liquidations by global and domestic investors leave governments with little choice but to initiate corrective steps. In this environment, the moment investors get so much as a whiff of inflation, asset positions are liquidated, equity prices fall and long-term interest rates rise, at times leaving the central bank with little choice but to hike short-term interest rates.
There has been an huge expansion in the supply of credit relative to income, since controls on the supply of credit were eliminated during the 1980s. Private sector debt to gross domestic product has increased by more than one-third since 1982, after having remained stable for more than three decades. While debt relative to income has risen sharply for businesses and households during this period, in comparison with net worth, debt levels have declined, primarily because of the enormous rise in equity prices.
Debt levels and asset valuations have increased much more rapidly than incomes since 1982. Rising debt levels have fueled asset price appreciation, while income growth has failed to keep pace. The precipitous decline in interest rates in recent years has obscured this development. This explains why a sharp increase in interest rates could trigger a dramatic decline in equity prices, as well as an abrupt end to the economic expansion.
In short, the explosion in debt that began in the 1980s has contributed to the equity market bubble in the 1990s. Since December 1994, the market value of the U.S. stock market has increased by more than $11 trillion, to about $16 trillion. This increase in paper wealth has caused saving rates among increasingly confident U.S. households to decline to a post-war low. While fundamental factors -- such as lower inflation, longer expansions, improved revenue expectations, and increased productivity growth -- have contributed to the recent appreciation of U.S. equities, these factors alone cannot explain why equity prices have doubled since 1994.
Rather, the increased supply of cheap credit, liquidity and flows of foreign capital have fueled asset price appreciation, leaving little doubt that favorable liquidity and euphoric market conditions can dominate financial market fundamentals for extended periods. As one market participant remarked, "Markets can remain irrational for far longer than you or I can remain solvent."
In the current environment, these circumstances pose a conundrum to central banks. So how does the Fed deal with soaring asset prices?
It could choose to tighten monetary policy to deflate the asset price bubble. Such a move would tend to slow real economic growth. The market bubble in Japan burst in 1990 only after the Bank of Japan hiked short-term interest rates by some 300 basis points. Its subsequent decision not to ease monetary policy until more than six months later contributed to the severe downturn in economic growth that persists today.
A decision to hike short-term interest rates in these circumstances in effect penalizes real economic activity for the excesses of the financial markets. Thus the Fed has been coy about whether asset price bubbles influence its monetary policy deliberations. However, its recent decisions to hike short-term interest rates, while justified as pre-emptive moves against potential inflationary pressures, clearly were targeted at reducing the use of leverage in pumping up asset prices.
The quarter point increase in short-term rates in February 1994 triggered an unanticipated market panic about potential inflationary pressures that eliminated $1.5 trillion in market value for global bonds by the end of that year. Since 1994, the Fed has provided advanced notice of its intentions to raise rates. The rate hike in November 1999 was less well advertised, but quietly confirmed the Fed's concern about the relationship between leverage and asset prices.
While the Fed today clearly includes asset prices in its deliberations about monetary policy, its modest actions have done little to stem the rise in equity market prices. Some have suggested the Fed raise margin requirements to reduce the use of credit in financing stock market transactions without affecting real economic activity. While such a step would communicate to the markets that the Fed is seriously concerned about leverage, the practical effects would be negligible. Money is fungible and numerous alternative sources of liquidity (e.g., the repurchase market) are readily available.
With inflationary pressures now embedded in asset prices, what happens if and when debt ratios reach unsustainable heights relative to incomes and asset prices adjust?
This is naturally a concern to the Fed. It is difficult to believe that economic growth, profitability and credit can be sustained indefinitely at the current pace. If the adjustment occurs in a panicked fashion and credit seizes up, the Fed will step in and inject liquidity (as it did in October 1987 and again in October 1998) to insulate real economic activity from the deflationary forces that otherwise could be unleashed.
While this introduces moral hazard ("heads I win, tails someone else loses") with long-term consequences for market prices that are not well understood, the Fed has little choice but to insulate real economic activity from a collapse in confidence.
In a liquidity-driven (i.e., liberalized) financial environment, boom-bust cycles leave central banks with few palatable options. While the structural changes described above have indeed extended the life of economic expansions, they also have created new sources of financial instability. The tendency for market prices to overshoot has intensified.
The relationship between asset prices, debt ratios and income growth are key, and the conundrum facing the Fed and other central banks across the globe becomes increasingly complex the further asset prices rise.
John M. Balder Jr. is director of fixed-income marketing and client services at Grantham, Mayo, Van Otterloo & Co., Boston.
