How the Fed Should Measure Inflation
The Federal Reserve has repeatedly pointed to subdued inflation as a justification for carrying on with its extraordinary efforts to stimulate the U.S. economy. It should be paying much more attention to a trend that its inflationary gauge is missing: the tremendous run-up in the prices of all kinds of assets.
One need look no further than the stock market to see that something is awry. In 2013, U.S. equity prices rose 28.3 percent in inflation-adjusted terms, while the comparable pace of growth in the broader economy was only 2.2 percent. In other words, in real terms, equity prices grew almost 13 times faster than the economic activity required to justify them -- the highest ratio since the abandonment of the gold standard in 1971. In 2014, the ratio is on track to exceed 5 for the third year in a row.
Such large disparities often end badly. In developed-nation peers, the ratio of real equity appreciation to real gross-domestic-product growth has topped 5 for at least three straight years on seven occasions since 1971 -- once in Australia, twice in France, twice in Germany, once in Switzerland and once in the U.K. None of the streaks lasted for more than four years, and the hangovers were ugly: In the following year, equity prices declined by an average of 16.4 percent in inflation-adjusted terms.
By looking only at consumer prices and wages, the Fed's inflation barometers focus on a part of the picture that is no longer representative. Globalization has put a ceiling on the prices of many goods and services. Technological advancements such as robotics have provided a similar check on wage growth by lowering the demand for human labor. As a result, the relationship between monetary policy and traditional inflation indicators has frayed. In a world where financial innovation has given almost everybody access to credit, easy money flows right past goods and services into asset markets, where it pushes up the prices of stocks, bonds and real estate.
Some of the most devastating financial downturns in recent history were engendered by asset inflation. The collapse of Japanese financial assets and real estate in the early 1990s is the archetype. Even as credit expanded by 11 percent per year in the late 1980s and asset prices surged, consumer prices rose just 1 percent annually and offered no clue of the impending disaster. More recently, an asset price collapse in the U.S. triggered the 2008 financial crisis. Again, despite massive credit growth and asset inflation, growth in U.S. consumer prices was subdued.
There are always rationalizations for asset inflation. Many today would say that the boom in equity prices is justified by increased corporate earnings. Those profits, though, are heavily dependent on cheap and easy credit, which has allowed companies to boost returns by increasing leverage, paring down interest costs and buying back shares. The real driver behind rising markets appears to be an expectation that the Fed's accommodative monetary policy will keep pushing prices up. Interest rates are effectively negative: The expected increase in asset prices exceeds the cost of borrowing the funds needed to buy those assets.
So what can the Fed do? To become a more effective custodian of the U.S. economy, it needs to adopt an inflation metric that incorporates both consumer prices and indicators more closely correlated with asset inflation.
Corporate credit growth might be a good place to start. Its excessive expansion has consistently preceded modern financial crises, both internationally and domestically. It has spiked relative to real GDP in the U.S. on three occasions in the last quarter century: during the heart of the tech bubble from 1997 to 1999, prior to the 2008 financial crisis and, ominously, in 2012 and 2013.
If the Fed simply averaged the consumer price index and corporate credit growth, the informational value of the combined indicator would be vastly improved. For example, the CPI grew by just 2 percent annually in the years before the tech bubble burst. The hybrid indicator rose by 5.4 percent annually and would have signaled overheating. In 2006 and 2007, the indicators read 3 percent and 5.9 percent, respectively. Once again, the latter could have warned of the conflagration to come.
This is just one idea. There are certainly other useful proxies for asset inflation. This does not detract from the broader truth that the Fed must adopt a metric that more honestly assesses the inflationary impact of its policy. The current surge in asset prices is an opportunity for policy makers to adapt and prove their mastery of recent history by ensuring it does not repeat itself.
(Matthew Schoenfeld was a member of the Special Situations Group at Morgan Stanley until Aug. 1. He plans to join the investment firm Driehaus Capital Management LLC in September.)
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