Risks of asset bubbles are growing

Risks of asset bubbles in some markets are growing

If such a bubble exists, it seems appropriate that the markets are only pricing in a modest tightening of monetary policy from the likes of the Fed.

Inflation at the moment in the US is 6.2% on the annual headline CPI measure and 5% in terms of PCE prices. Both are considerably above the 2% target for PCE prices and yet, if you look at the fed funds futures strip, for instance, the market sees rates at only 1.7% by the end of 2024. Look at this compared to last rate-hike cycle that ran from late 2015 to the end of 2018. Back then inflation started out at under 1% in CPI terms and yet the Fed took rates up to 2.5% within three years.

In other words, despite starting from a dramatically higher level of inflation now, the market is not pricing in a more aggressive rate-hike cycle than the last one. On first glance, this seems odd; if inflation is so much higher surely it will take much more monetary tightening to bring it under control? So instead of an end-point for the fed funds target that is under 2%, perhaps the rate will have to rise much further; certainly higher than the 2.5% ‘neutral’ rate that the FOMC suggests is in play right now.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy, said: “We would agree that bringing inflation under control will require tighter monetary conditions. At the moment, conditions are very loose indeed, which is a function of the ‘everything bubble’ that has helped lower real yields and inflate asset valuations. But just as financial conditions can be loosened by the everything bubble, so rapid tightening can also occur if asset prices go into sharp reverse”.

Central banks don’t usually respond to asset inflation, except for macroprudential policies when house price affordability and speculation becomes problematic. But they do tend to respond to inflation in goods and services (CPI) because that’s where their mandate lies. And, in order to prevent excessive inflation, central banks would tighten policy so that monetary conditions become restrictive, not expansive. However, as just mentioned, in the case where there’s an everything bubble in asset prices, the central bank, might find that it only requires a very modest rise in rates to tighten conditions sufficiently because asset prices will crumple and create the necessary tightening of financial conditions to stop CPI inflation in its tracks.

In fact, we’d expect there to be an overtightening the bigger the asset bubble and, right now, there’s probably a case for arguing that many assets, both financial and real – like housing – are so inflated that it will only take a very modest bout of tightening from central banks to send asset prices into reverse and so create a tightening of financial conditions that goes well beyond that necessary to bring inflation back to target. All of this would operate, of course, through a very sharp slowing of economic growth to bring demand back down into line with the reduction in supply that we have seen since Covid began.

“We can put this another way and argue that, if we could calculate what policy rate might be required from the Fed, absent any financial market influence, to bring inflation back to target, it is likely to be far above the level required once we bring the impact of asset price deflation into the equation. Hence, one way we can rationalise the relatively low rates in the US futures strip right now is to argue that the market is taking account of the fact that rising US policy rates are not the only (and perhaps not even the most important) way to tighten financial conditions sufficiently to break the back of inflation. The danger in this theory, though, is if asset prices prove impervious to higher US rates. In this case, more weight will be placed on the Fed to push financial conditions back to where they need to be – necessitating far higher policy rates than those discounted by the market. This is clearly a risk but it is not our base case at the moment”, Mr. Steve Barrow said.