Asset Inflation: The Missing Policy Indicator

Although statements have been made by some Federal Reserve officials such as Kevin Warsh and Thomas Hoenig that interest rates will have to rise sooner and faster than the market expects, the Fed continues to reiterate that

economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

High unemployment and concerns about deflation are holding the Fed back from raising rates from nearly zero percent. Going by the Fed’s favored measurements of inflation that exclude or give less weight to all the products and services consumers need to survive, it will be some time before the Fed acknowledges that inflation exists and must be tamed with tighter monetary policy.

One key indicator of inflation that economists as well as Ben Bernanke and his predecessor Alan Greenspan refused to acknowledge is asset inflation. Nearly zero interest rates “for an extended period” are creating asset inflation as investors seek higher returns from stocks, commodities, and the Treasury market.

Greenspan continues to warn that the government should not over regulate financial markets since a major financial crisis only comes along “once every hundred years.”

Beyond the Maestro’s memory lapses (1997 Asian crisis, 1998 LTCM, 2000 tech wreck, and the 2007-08 credit and housing bubbles we’re still mopping up), this highlights the importance of factoring asset inflation into monetary policy. Greenspan believes if bank capital requirements included long tail events, the banks would not be profitable enough in good times.

Economists and Fed officials would no doubt claim it is impossible to measure what part of asset prices are truly inflated versus real increased worth. But dissecting asset inflation versus real growth is not that difficult.

Looking at the stock market, if certain individual stocks increase in value while the remaining stocks do not, those individual stocks might be moving higher based on fundamental factors such as sales growth. If the entire market is rising in unison, than either economic fundamentals must be strong (low unemployment, etc.) or a bubble is forming. The latter reflects the presence of inflation in the stock market.

Commodity prices, particularly in precious metals and crude oil, are also exhibiting asset inflation. When you strip out current and short term industrial needs, you are left with inflation. Demand for gold jewelry is way down, yet gold topped $1,055 this week.

According to the IEA, OPEC is producing 1.6 million barrels a day above their 24.845 million barrels a day. And oil trading companies, refineries, and banks such as Goldman Sachs (GS) are paying to store vast amounts of crude oil in offshore tankers.

While crude prices have dropped from their mid-2008 peak, oil prices hovering in the $65-75 a barrel range does not reflect the utility demand relative to supply. Treasuries are behaving very much like commodities and precious metals; all three are gold alternatives.

It would not have been difficult to calculate the high level of asset inflation present during the housing bubble either. Yet as a member of the Fed Board of Governors at the time, Bernanke believed that improving economic fundamentals were behind the rapid increases in home prices throughout the nation.

If a handful of homes in a neighborhood are selling at higher prices because the sellers have added value in some way, or certain external dynamics (for instance, more employment opportunities in the area) increased the value of an entire neighborhood, then property values are increasing due to fundamental factors.

But during the boom years, every home, neighborhood, city, state – in essence the entire nation’s house prices- rapidly increased in value. Condition was not even a factor.

If the Fed factored in asset inflation in setting monetary policy, Greenspan could have never kept interest rates at 1% for so long. Nor could he have so slowly raised rates a measly 25 basis points at a time.

The current Fed feels monetary policy can remain overly accommodative until the velocity of money increases because their measure of inflation does not include asset bubbles. But the danger is that money velocity can change far more rapidly than the Fed can withdraw liquidity from the currency supply.

The world has already lost confidence in our “strong dollar policy” so that when the export dominated countries realize that our consumer economy will never return to what it was, they will stop supporting our currency. This will reduce consumer spending recycled into treasuries from China and friends leading to the real collapse in the dollar.

Hopefully the world will force our stubborn and arrogant Fed to act responsibly.

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Comments

[socrateaz:]

Interesting and real. Have you noticed anyinvestment touted as a way to make money inflates with the amount of people who believe its value is increasing. Does not matter what the asset is. There is an intrinsic value based on total value of all assets. Stocks are indications of business health. But when you buy to make money (as most investors are currently doing) You create a bubble. How many invest for long term today? What kind of bubble is being blown into the future? The US keeps patching the ballon, But are they fixing it? The fix is: Stop and reverse foriegn deficit, shrink the government to under 10% GDP, and create more middle class. All will hurt. Education is in a bubble too! Society does need many educated people, But there is only so much need. Many of the educated are as brainwashed as the are educated. When decisions are made on pure tested science then good decisions are likely. When they are made on beliefs ( as most seem to be )then everything is a crap shoot. The desire to believe overcomes reality. Enviornmental science, political science, social science and most unprovable so called sciences are nothing more than religions based on beliefs of those in power! Hopefully mankind will recognize and correct such. I really am not optimistic though.

Oct 11 10:01 AM

[Tony Daltorio:]

Very good article on the dangers of asset inflation. Asset inflation has been ignored not only by Greenspan and Bernacke (what ever happened to taking away the punch bowl?), but also by the deflationists who somehow don't see this massive dangerous inflation staring them in the face (I guess they're stock market bulls).

Oct 11 10:44 AM

[Gary A:]

Asset inflation with gas over 4 dollars a gallon will kill this fake rally once and for all. Bernanke better know this.

Oct 11 10:54 AM

[Roger Knights:]

"The world has already lost confidence in our “strong dollar policy” so that when the export dominated countries realize that our consumer economy will never return to what it was, they will stop supporting our currency."

I've been wondering why the price of Treasuries has held up. Perhaps it's because our officials have sold China on the idea that our consumers will soon start spending. If so, then when this fails to come to pass, then Treasuries could decline far and fast.

Oct 11 01:34 PM

[Albertarocks:]

I think the fact that general inflation is damaging to all citizens is irrelevant to Bernanke, as long as asset inflation is beneficial to his dark lords. Low interest rates serve that purpose nicely, not to mention that his entire cabal know how to profit emmensley from the dollar carry trade.

Greenspan served his masters well, with full knowledge that what he was doing was harmful to America and it's citizens in the longs run. Totally irrelevant! Bernanke has a copy of the same playbook so I don't think he's going to be raising interest rates any time soon, perhaps until he sees the peasants on the verge of riot, which might be sooner than he thinks. But whenever the time comes, you can bet your bottom dollar that he and his entire den of thieves will have positioned themselves perfectly just prior to the announcement.

I'd think that a sudden surge in the number of calls on JPM might be a canary in the coal mine. Whoever it is who's selling those calls knows something, and the only people who know something with enough confidence to sell calls in the financial sector are the owners of the casino.

Oct 11 02:10 PM

[Earthizen:]

Wouldn't the reverse be true, too? Whoever is buying the JPM calls must know something!? For every seller, there is a buyer. Unless you are a market maker, you don't know who is doing the buying or selling.


On Oct 11 02:10 PM Albertarocks wrote:

> I think the fact that general inflation is damaging to all citizens
> is irrelevant to Bernanke, as long as asset inflation is beneficial
> to his dark lords. Low interest rates serve that purpose nicely,
> not to mention that his entire cabal know how to profit emmensley
> from the dollar carry trade.
>
> Greenspan served his masters well, with full knowledge that what
> he was doing was harmful to America and it's citizens in the longs
> run. Totally irrelevant! Bernanke has a copy of the same playbook
> so I don't think he's going to be raising interest rates any time
> soon, perhaps until he sees the peasants on the verge of riot, which
> might be sooner than he thinks. But whenever the time comes, you
> can bet your bottom dollar that he and his entire den of thieves
> will have positioned themselves perfectly just prior to the announcement.
>
>
> I'd think that a sudden surge in the number of calls on JPM might
> be a canary in the coal mine. Whoever it is who's selling those
> calls knows something, and the only people who know something with
> enough confidence to sell calls in the financial sector are the owners
> of the casino.

Oct 12 08:52 PM

[Albertarocks:]

On Oct 12 08:52 PM Earthizen wrote:

> Wouldn't the reverse be true, too? Whoever is buying the JPM calls
> must know something!? For every seller, there is a buyer. Unless
> you are a market maker, you don't know who is doing the buying or
> selling.<

No, I don't think so. 90% of the time (this is a proven percentage, not just some exaggerated number I'm pulling out of the air) it's the sellers of options who make the money, for both puts and calls. But it's also the sellers of options who are at most risk, in the event they're wrong. So they take more risk but get rewarded 90% of the time.

It's joe average investor like me who buys those options, with less risk than selling them, and loses his money 90% of the time. So the only people who have the balls to sell options are the ones who have the inside information. I mean, it just has to be insiders, no? Who else would be crazy enough to sell calls in the financial sector. I sure wouldn't be standing in front of that train unless I knew it was suddenly going to stop and reverse on a dime.

Having said that... did you know that tonight (Oct. 12) after hours, I read in an article that today there was a huge flurry of activity in options on XLF, and guess what! There were tons and tons of calls purchased (out of the money no less). From my perspective that can mean only one thing... the banks are going to fall.

Somebody must know what the reports are going to be, and it appears they're going to stink. I'm thinking its going to smell like somebody beat a skunk to death with a salmon.

Oct 12 10:24 PM