Confusing times lead to conflicting concerns. Worries over current deflation run into worries about explosive inflation down the road and now there are growing worries over another global asset price bubble. All of these worries are valid, but the possible return of the asset price bubble is the newest and perhaps most serious in the near term. As with the previous bubble, however, commentators seem to be conflating the causes.
The simple evidence of a bubble begins with the Dow Industrials pushing toward 10,000. Who knows what the right level ought to be, but a 53 percent one year jump strikes many as excessive. Commodity prices are also up significantly – oil has more than doubled in price since February while gold is up 35 percent.
If bubbles are building, what are the causes? One candidate is the huge amount of liquidity the Fed has pumped into credit markets. This is reminiscent of the excess money creation earlier in the decade that contributed massively to the financial crisis. However, while this money creation has been enormous, with excess reserves held at the Fed now almost $1 trillion above normal, almost all remains at the Fed rather than released into the credit system. So money creation poses a threat for future inflation, but pose little risk of current bubble building.
Beyond the US, China and Japan may be vying for the position of world’s second-largest economy but there’s no question which has the hotter asset markets or which is driving up global commodities prices. According to the People’s Bank, by the end of September Chinese broad money growth reached a blistering 29 percent year-on-year featuring a 34 percent jump in outstanding loans. In 2007, this would have been destructive monetary policy, now it’s called stimulus. And unlike the Fed’s stimulus, this is real credit creation, not reserves held at bay at the central bank.
Another source of bubble pressures is simultaneously international and traces back Fed policy. As others have noted, banks are now borrowing from the Fed at a near zero nominal interest rate and buying all manner of assets earning positive returns. When foreigners perform this magic, they get the extra benefit of a falling dollar so they earn a profit on the exchange rate, too. Called the carry trade, the net effect is to drive down the price of risk. Recall it was the collapse in the price of risk globally that was the proximate cause of the previous asset bubble.
This financial jui-jitsu of borrowing at zero or negative rates and investing at positive rates could also help explain why interest rates are so low. The 10-year Treasury bond has hovered below 3.5 percent for months, when a much higher rate is suggested by the state of the economy and inflation expectations. Whatever the cause, if interest rates are artificially low for whatever reason, then asset prices are almost surely artificially high and another painful correction is in the offing. The witches of Macbeth could not stir a more bitter brew.
Co-authored by Derek Scissors.