Central Banks Risk Asset Bubbles in Battle With Deflation
Central banks are finding it’s easier to push up stock and home prices than it is to prevent inflation from falling short of their targets.
While declining costs for everything from gasoline to coffee can be good news for consumers, disinflation makes it harder for borrowers to pay off debts and businesses to boost profits. The greater danger comes when disinflation turns into deflation, which leads households to delay purchases in anticipation of even lower prices and companies to postpone investment and hiring as demand for their products dries up.
“There is definitely a whiff of disinflation again taking hold globally,” Robert Sinche, global strategist at Pierpont Securities Holdings LLC in Stamford, Connecticut, said Nov. 5 on Bloomberg Radio’s “Bloomberg Surveillance.”
Federal Reserve Chairman Ben S. Bernanke and his central-bank counterparts are trying to avert the deflationary danger by pumping up their economies with lower interest rates and monetary stimulus. They have bet the run-up in stock and home prices they’ve engineered would boost consumer and corporate confidence and spur faster growth and higher inflation. Now they’re having to maintain or intensify their aid -- running the risk those efforts do more harm than good by boosting equity and property prices to unsustainable levels.
“You have a wall of liquidity” that’s “leading to asset inflation and eventually to bubbles,” Nouriel Roubini, chairman of Roubini Global Economics LLC, said Nov. 7 on Bloomberg Television’s “Street Smart.”
Global inflation will be about 2.8 percent this year, the second-lowest since World War II, amid high unemployment in developed nations and slowdowns in emerging markets, according to Bruce Kasman, chief economist at JPMorgan Chase & Co. in New York. Even after policy makers slashed interest rates and bought bonds, about two-thirds of 27 inflation-targeting central banks tracked by Morgan Stanley still are undershooting their goals or watching prices rise in the lower end of preferred ranges.
“We have seen, in the last months, deflationary tensions building up,” Laurent Freixe, executive vice president of Nestle SA, the world’s biggest food company, said in an Oct. 17 conference call. “There is no growth in the marketplace, so everyone is fighting for a share of a shrinking pie.”
The European Central Bank surprised investors last week when it unexpectedly halved its benchmark rate to a record low 0.25 percent to combat what President Mario Draghi called “a prolonged period of low inflation.” A slew of emerging markets -- including Israel, Chile, Hungary, Sri Lanka, Peru and Mexico -- also have eased policy since September began.
Fed officials repeatedly have stressed their intention to keep their target for short-term rates near zero until the U.S. economy and inflation pick up, even as they consider whether to start reducing their $85 billion in monthly bond purchases.
Bank of Japan Deputy Governor Kikuo Iwata declared on Oct. 27 the BOJ will keep buying assets until it hits its 2 percent inflation goal. Japan has grappled with deflation for the last dozen years, with its central bank hamstrung by a liquidity trap that’s caused consumers and companies to save the money it has injected into the economy.
The central-bank largess is buoying world stock markets, as investors seek higher returns than they can get with government bonds. Japan’s Nikkei 225 (NKY) Stock Average is up 40 percent this year. The MSCI World Index, which includes both emerging and developed country markets, has risen 19 percent.
“The surprise ECB rate cut underlines our positive outlook for global equity markets,” said Trevor Greetham, director of asset allocation at Fidelity Worldwide Investments in London, who helps manage $260 billion. “A sharp rise in inflation would change things, but there’s not sign of it.”
Helped by the Fed’s loose money, the Dow Jones Industrial Average (INDU) will rise to 18,000 in the next year or two, said Allen Sinai, chief executive officer of Decision Economics Inc. in New York. The gauge climbed to a record 15,783 on Nov. 11. “I’ve never seen a central bank that has been so open” to a rising stock market, he said.
Home prices also are rising. The S&P/Case-Shiller index of property values in 20 U.S. cities climbed 12.8 percent in August from a year earlier, the fastest pace since February 2006. U.K. house prices increased for a ninth month in October, while apartment values in parts of Germany have jumped by an average of more than 25 percent since 2010.
The stimulus is having less effect on economic growth, with continued weakness pressuring inflation. The International Monetary Fund cut its global outlook last month to 2.9 percent this year and 3.6 percent in 2014. Both are down 0.2 percentage point from the July forecast.
The easy money lacks punch because the “pipes” that carry stimulus from financial markets to the rest of the economy are “clogged,” Mohamed El-Erian, Pimco’s chief executive officer, said in an interview. Banks are wary of lending and companies are chary of spending after suffering the worst financial crisis and recession since the Great Depression.
Commodity prices have fallen as demand from China and other developing economies has ebbed. The Washington-based IMF forecasts oil prices will slump 7.7 percent next year while non-fuel commodities will drop 2.9 percent in dollar terms. It also projects governments will keep cutting budgets, with the aggregate deficit of advanced nations at 4.5 percent of gross domestic product this year and 3.6 percent next year.
The region most at risk is the 17-nation euro area, where banks are deleveraging and wages are falling in nations including Spain. The ECB already is turning more aggressive after inflation slumped to a four-year low of 0.7 percent in October, less than half its target of just below 2 percent. Prices may not pick up any time soon, Draghi has warned. Unemployment is a record 12.2 percent, and the European Commission said last week it anticipates growth of just 1.1 percent in 2014.
“Deflation is not imminent, but it has to be on the mind of central bankers,” ECB Governing Council member Ewald Nowotny said yesterday in Vienna.
The central bank still needs to do more because “a ‘Japanification’ of the euro area is a clear and present danger,” Joachim Fels, co-chief global economist at Morgan Stanley in London, said in a Nov. 10 report to clients.
Avoiding that fate may be hard. While Draghi has raised the possibility of charging banks to park cash at the ECB, colleagues have warned a negative deposit rate could hurt banks’ profitability and make them even less willing to lend.
Fed-style quantitative easing also has been ruled out, given the ECB is barred by European Union treaties from financing state debt. Still, policy makers have room to cut their benchmark more and also haven’t announced whether they will again lend money to banks for long periods of time.
Japan shows that “because inflation is very slow-moving, once you get in the liquidity trap, you have to move fairly forcefully to get out and to get inflation up,” said Kenneth Rogoff, a professor at Harvard University in Cambridge, Massachusetts, and a former IMF chief economist.
The Fed has found that expanding its balance sheet -- now at a record $3.85 trillion -- hasn’t been a panacea. Since the U.S. recession ended in June 2009, growth has fallen short of its predictions, and in nine of the last 10 estimates for 2013, policy makers have lowered their forecasts. The central tendency -- which excludes the three highest and three lowest projections -- now shows growth of 2 percent to 2.3 percent, compared with 3.5 percent to 4.3 percent in April 2011.
Inflation, too, is lower than projected and has undershot the Fed’s 2 percent target starting in May 2012. The personal-consumption-expenditures index, the board’s preferred gauge, increased 0.9 percent in September from a year earlier, matching April for the lowest since October 2009. The rate will stay low in 2014, at about 1.25 percent, according to Sinai.
Bernanke said in June he viewed the slowdown as reflecting “some factors that are likely to be transitory.” The ensuing months have complicated the Fed’s strategy and challenged the notion that underlying demand would boost prices in the second half of the year.
“They’re in the process of debating what should be their reaction,” said Ethan Harris, co-head of global economics research at Bank of America in New York. “They know that inflation’s very hard to change, that it’s a sticky process; it can take years to move.”
El-Erian said he expects the Fed to remain “hyper-active” in its efforts to aid the economy in 2014, though it might change its mix of tools. It will “slowly -- and I stress slowly” moderate its asset purchases while strengthening its pledge to keep interest rates low for a long time, he said.
Janet Yellen, currently the central bank’s vice chairman, will face that balance if she’s confirmed as Bernanke’s replacement. She will appear before the Senate Banking Committee tomorrow in the first step of the approval process. Lawmakers probably will question her over the “dilemma” confronting the Fed: preventing disinflation and a slowdown in the economy while avoiding the creation of asset bubbles, John Makin, a resident scholar at the American Enterprise Institute in Washington, said today in a conference call with reporters.
The Fed said Oct. 30 it will press on with its monthly bond buying and continue to hold short-term rates near zero at least as long as unemployment is above 6.5 percent and forecast inflation is below 2.5 percent. The joblessness rate in October was 7.3 percent.
In Japan, the BOJ has had some success in battling deflation after swinging into action in April, when it pledged to double the monetary base through purchases of government bonds and other assets.
Consumer prices excluding fresh food rose 0.7 percent in September from a year earlier, down from 0.8 percent in August, the fastest increase since November 2008. The yen has dropped about 20 percent against the dollar in the past year, boosting prices of imported goods.
“Core inflation is now no longer negative,” said Jerald Schiff, deputy director of the IMF’s Asia-Pacific Department. That “is a major victory in the Japanese context.”
Financial-market expectations of inflation also have risen, to between 1 percent and 1.5 percent, though they remain below the BOJ’s goal, he said.
“Japan’s deflationary trend is changing, but it’s still impossible to achieve the 2 percent price target in two years,” said Nobuyasu Atago, principal economist at the Japan Center for Economic Research in Tokyo and a former BOJ official in charge of price data.
The central bank has signaled it may hold further fire until it can evaluate the effects of a sales-tax increase timed for April. After that, policy makers probably will amplify stimulus in the second quarter, according to 20 of the 34 economists surveyed by Bloomberg News last month.
Emerging markets, which have been in danger of overheating, mostly have welcomed the fall in global inflation, JPMorgan’s Kasman said. That’s enabled their central banks to take action to boost their economies.
“It allows more policy flexibility in that part of the world where we need growth leadership, and that is the emerging world,” Pierpoint’s Sinche said.
Brazil, India and Turkey nevertheless will probably continue to tighten policy as falling currencies fan prices, according to Harris. Indonesia unexpectedly raised its key rate 25 basis points yesterday to 7.5 percent to contain inflation and shore up the rupiah.
Other developing nations may act to keep their currencies from rising too much. The Czech Republic last week intervened in foreign-exchange markets to weaken the koruna, and Peru cut rates as exports slow.
While the aggressive actions that central banks have taken haven’t done all that much for global growth, they have boosted asset values worldwide, pushing home prices from Canada to Australia and Sweden to China to levels that may turn out to be unsustainable. Some Fed officials have pointed to costlier homes, farmland and bonds as causes for concern.
“We’ve seen real bubble-like markets again,” Laurence D. Fink, chief executive officer of BlackRock Inc., the world’s largest money manager with $4.1 trillion in assets, said at an Oct. 29 panel discussion in Chicago.
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