New York Fed Inflation Gauge is Bad News for Bulls
U.S. financial markets have in the last 20 years experienced three unprecedented booms in asset prices and two busts. During this span, the market value of real and financial assets held by households has increased more than $70 trillion, an astounding amount on its own, but even more so when one considers the huge losses following the dot-com and housing bubbles.
What’s behind the huge asset gains and losses? What role, if any, has monetary policy played in the asset cycles? Given that the prior two asset cycles ended with huge losses, will the current cycle end the same way? The answer to that last question may lie in a novel new inflation gauge devised by the Federal Reserve Bank of New York.
History shows that asset price cycles (i.e., wealth creation) are highly correlated with economic growth cycles. That makes sense because each economic cycle includes new investment and saving, expanding the stock of real and financial assets while also increasing the market value of existing assets.
Throughout most of the post-war period, asset cycles or wealth cycles ran roughly parallel to the economic cycle as the scale of gains has more or less matched the gains in nominal income. Yet, in the last three economic growth, cycles real and financial asset values have become unhinged, rising markedly faster than the growth in nominal income. As of the end of the second quarter, household net worth was 670 percent of income, and is poised to go higher following the surge in asset values since midyear. The current cycle far surpasses the prior highs of 654 percent in 2006 during the housing bubble and 613 percent during the equity market bubble in early 2001.
Some may argue that the recent explosion in asset values could be tied to the new technological advances and gadgets. While these new innovations have clearly added value to the economy and created enormous wealth in the process, they cannot fully explain the broad surge in all types of real and financial asset values.
In a fundamental sense, asset values are highly contingent on the current level of and future expectations for inflation and interest rates. To be sure, a persistently low inflation rate suggests little downside risk to the economy, creating a vision of endless and uninterrupted economic growth, boosting investor confidence and risk taking.
Monetary policy has played a key role in asset price cycles. Not only has the Federal Reserve used its balance sheet to buy trillions of dollars of financial assets, boosting the values of all type of assets and anchoring long-term rates in the process, it also directly linked its official rate decisions to a specific rate of consumer inflation. The transparency of its future policy path has created the impression of an accommodative monetary policy, encouraging more risk-taking in asset markets.
More than 20 years ago, former Fed Chairman Alan Greenspan asked an important question “what prices are important for the conduct of monetary policy?” The query was directly related to asset prices and whether their stability was essential for economic stability and good performance. No one has ever offered a coherent answer even though the recessions of 2001 and 2008-2009 were primarily due to a sharp correction in asset prices.
A new underlying inflation gauge, or UIG, created by the staff of the New York Fed may finally provide the answer. Its broad-based measure of inflation includes consumer and producer prices, commodity prices and real and financial asset prices. The New York Fed staff concluded that the new inflation gauge detects cyclical turning points in underlying inflation and has a better track record than the consumer price series.
The latest reading shows inflation of almost 3 percent for the past 12 months, compared with 1.8 percent for the consumer price index and 1.8 percent for core consumer prices, which exclude food and energy. Since the broad-based UIG is advancing 100 basis points above CPI, it indicates that asset prices are large, persistent and reflect too easy monetary policy.
The UIG carries three important messages to policy makers: the obsessive fears of economy-wide inflation being too low is misguided; monetary stimulus in recent years was not needed; and, the path to normalizing official rates is too slow and the intended level is too low.
Harvard University professor Martin Feldstein stated in a recent Wall Street Journal commentary that “The combination of overpriced real estate and equities has left financial sector fragile and has put the entire economy at risk.” If policy makers do not heed his advice odds of another boom and bust asset cycle will be high -- and this time they will not have the defense mechanisms they had after the equity and housing bubbles burst.
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