How Asset Inflation Will End — This Time

Life after death for asset inflation: this is what happens when “speculative fever” remains high even after monetary inflation has paused. This may well have been the situation in global markets during 2019 so far. But history and principle suggest that life after death in this monetary sense is short.

Readers may find it odd to be talking about a pause in monetary inflation at a time when the Fed has cancelled programmed rate rises and the ECB has embarked (March 7) on yet further “radical” policy moves. Moreover, the “core” US inflation rate (as measured by PCE) is still at virtually 2 per cent year-on-year.

Yet we know from past cycles that in the early stages of recession many market participants — and, crucially, central banks — mistakenly view a stall in rate rises or actual rate cuts as stimulatory. Later with the benefit of hindsight these policy moves turn out to be insufficient to prevent a tightening of monetary conditions already in process but unrecognized.

Even had monetary conditions been easing rather than tightening, it is highly dubious whether this difference would have meant the powerful momentum behind the business cycle moving into its recession phase would have lessened substantially.

(As a footnote here: under a gold standard regime there is no claim that monetary conditions will evolve perfectly in line with contracyclical fine-tuning. Both in principle and fact monetary conditions could tighten there at first as recessionary forces gathered. Under sound money, however, contracyclical forces would emerge strongly into the recession as directed by the invisible hand.)

Under a fiat money regime, monetary tightening can occur in the transition of a business cycle into recession, despite the opposite intention of the central bank policy-makers, due to endogenous factors such as an undetected increase in demand for money or a fall in the underlying “money multipliers.” Quite possibly, what the markets first celebrated as a seeming Fed put eventually turns out to be a sick joke.

Like the policy of the central bank, the reported trend of officially measured inflation in goods and services market is a notoriously poor indicator of turning points in monetary inflation.

Fluctuations up and down in goods prices sometimes have nothing to do with monetary inflation. Students of Austrian school economics know that under sound money, prices would fluctuate in both directions for sustained periods. For example, there could have been a sustained period of falling prices under the influence of accelerated digitalization and globalization.

In the late stage of a business cycle expansion an upward drift of prices can form under the hypothesized sound money conditions and this may be happening in the present even as monetary inflation has waned.

Labor market normalization (return to balance) goes along with some pick-up of wages and productivity growth may coincidentally slow (perhaps related to a breather in the hectic pace of new technology application. In this cycle we could argue that the pace of globalization has slowed somewhat (of especially as the US confronts Chinese abuse of free market order in international economy). Maybe also the pace of digitalization has slackened (the “online” revolution surely does not proceed forever at the same hectic pace).

In sum, a late cycle rise of prices could be a false positive test of monetary inflation.

Moreover, just as official inflation data can be a lagging indicator of monetary inflation, so it is with the continuing symptoms of monetary inflation in the asset markets. Indeed, a Fed put may have inflamed those symptoms.

In searching for the presence (or not) of asset inflation we look for evidence of irrational forces under such banners as “search for yield” or “positive feedback loops.” A key focus is the carry trade, especially in currencies and credit. Alongside, we focus on the spread speculative narratives about which investors would be highly skeptical in sober rational mood (but monetary inflation erodes such skepticism). These characteristics can all outlive for some time monetary inflation, especially if the Fed has sought to exercise a put.

Even so, in this late stage the discerning monetary analysts can detect some tiredness about the narrative-telling. The chickens are coming home to roost from growing cumulative mal-investment – translating into pre-tax earnings peaking or going into reverse. Some disturbing counter narratives have emerged concerning the one-time hot speculations.

In many past business cycles, analysts in search of when the expansion and asset inflation are set to wane look for areas of unsustainable rises for key economic aggregates. In the last cycle, one example was residential construction in the USA. In other cycles it has been business spending overall — which would be broadly in line with Austrian School literature on the business cycle focusing on how monetary inflation distorts the relative price of capital goods in terms of consumer goods.

In this cycle though there has been no obvious such overall unsustainability at the level of broad economic aggregate in the US economy. In the emerging market economies by contrast, including China, that would be an easier case to make. In Europe or Japan, we could talk of the unsustainability of export sector growth based on emerging market bubble and their own manipulated cheap currencies.

Back to the US, the lack of obvious non-sustainability in a broad spending aggregate does not mean there is no recession danger — just the searchers for this must dig deeper. In particular, the overall mal-investment might be even greater than usual but concentrated in a few sectors where the speculative narratives have been intense — whether Silicon Valley or shale oil and gas. Mal-investment only shows up in many cases once the asset inflation and cycle expansion have come to an end.

In talking about main economic aggregates, the case can be made across the advanced economies that consumer spending might be in for a big fall once households realize that all was fantasy. Specifically, the high returns during the asset inflation from risk-assets including booming carry trades while they lasted made them tolerant of the manipulated low and widely negative returns on safe assets. Once gone, alarm sets in.

Even so there is a paradox to address about the present cycle. How has it been that such monetary wildness has gone along with apparent real economic moderation (no obvious unsustainable rise of broad economic aggregates)?

Fearing the Long Term

A plausible part-answer is that everyone and their dog know what the Federal Reserve and other central banks have been up to and all along have feared the eventual crash and great recession. Hence there has been a tendency for business owners to eschew long-gestation investments and focus on generating high returns via financial engineering instead (camouflaged leverage, momentum trading, carry trades).

Another part answer is the growth of monopoly power across the US economy as described by the star firm literature or more specifically in accounts of Big Tech. Specifically, the star firm theorists tell us that there is something about present technological advance — most likely its high specificity of investment much of which is intangible to the given firm with little scope for selling in a secondary market — which retards the percolation of progress beyond.

Monopolists respond often more sluggishly in their capital spending plans to manipulations down in the cost of capital than would firms in a competitive setting. Limiting supply is the name of their game.

Whatever the causes for subdued business capital investment overall in this cycle and more broadly for “real economic moderation” there is every reason to expect the real economic moderation which has coexisted with a wild monetary environment to end in immoderation. The illusion of economic moderation has fanned the carry trade into high yield credit and more broadly equity market valuations – and so the fall will be all the greater.


Brendan Brown is senior fellow (non-resident) Hudson Institute. As an international monetary and financial economist, consultant, and author, his roles have included Head of Economic Research at Mitsubishi UFJ Financial Group. He is also an Associated Scholar of the Mises Institute. His latest book is The Case Against 2 Per Cent Inflation(Palgrave, 2018) and he is publisher of “Monetary
Scenarios,” Euro Crash: How Asset Price Inflation Destroys the Wealth of Nations and The Global Curse of the Federal Reserve: Manifesto for a Second Monetarist Revolution.

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