A Response to Donald Kohn on Asset Bubbles

By: Doug Noland | Fri, Mar 17, 2006
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For the week, the Dow rose 1.8% and the S&P500 gained 2.0%. Economically sensitive issues shined, with the Transports up 2.4% and the Morgan Stanley Cyclical index up 3.8%. The S&P Homebuilding index jumped 7.4%, reducing the 2006 decline to 3.7%. The Utilities gained 2%, and the Morgan Stanley Consumer index added 0.9%. The broader market was strong. The small cap Russell 2000 jumped 2.7% (up 10.8% y-t-d) and the S&P400 Mid-cap index gained 2.5% (up 6.3% y-t-d). Technology stocks were mixed. The NASDAQ100 rose 2.3%, and the Morgan Stanley High Tech index increased 1.7%. The Semiconductors fell 1.0%, while The Street.com Internet Index rose 1.8%. The highflying NASDAQ Telecommunications index surged 4.65%, increasing 2006 gains to 20.8%. The Biotechs added 0.8%. Financial stocks were strong. On the back of enormous earnings, the Broker/Dealers jumped 3.4%, increasing y-t-d gains to 14.9%. The Banks gained 2%. With bullion up $13.15 to $554.20, the HUI gold index posted a 3.4% gain.

Newfound confidence the Fed is about to wrap things up... For the week, two-year US Treasury yields dropped 9 bps to 4.64%. Five-year government yields sank 15 bps to 4.62%, and bellwether 10-year Treasury yields fell 9 bps to 4.67%. Long-bond yields declined 3 bps to 4.72%. The 2yr/10yr was little changed by the end of the week, leaving the spread a positive 3 bps. Benchmark Fannie Mae MBS yields declined 5 bps to 5.85%, this week underperforming Treasuries. The spread on Fannie's 4 5/8% 2014 note was little changed at 34.5, and the spread on Freddie's 5% 2014 note narrowed slightly to 35.5. The 10-year dollar swap spread declined 0.25 to 53.5. Investment-grade and junk spreads were little changed this week. The implied yield on 3-month December '06 Eurodollars sank 16.5 bps to 5.03%.

March 14 - Bloomberg (Walden Siew): "Companies are selling floating-rate debt in the U.S. at the fastest pace ever as investors seek securities that will keep their value while the Federal Reserve raises interest rates. Borrowers sold $62.9 billion of floating-rate notes this year and are on track to beat the 2005 record of $302 billion, according to data compiled by Bloomberg."

Investment grade issuers included GE Capital $3.0 billion, Goldman Sachs $1.75 billion, Wells Fargo $1.5 billion, USB Capital $1.25 billion, Tyson Foods $1.0 billion, Shinsei Finance $700 million, World Savings $600 million, Clear Channel $500 million, HRPT Properties $400 million, Archstone Communities $300 million, Genworth Global $300 million, Compass Bank $275 million and Boston Edison $200 million.

Junk issuers included Quicksilver Resources $350 million.

Convertible issuers included Waste Connection $175 million.

Foreign dollar debt issuers included Uruguay $500 million, Trans-Canada Pipeline $500 million, Dominican Republic $300 million and Angiotech Pharmaceutical $250 million.

March 14 - Financial Times (Jennifer Hughesin): "Inflows into emerging market equities have set an annual record just 11 weeks into the year as investors continue to chase the higher returns seen in developing markets. In the week to March 8, $20.9bn has been poured into emerging market stock funds breaking last year's record of $20.3bn, according to Emerging Portfolio Fund Research. Brad Durham, a managing director of EPFR, said: 'While it is natural to assume that such strong inflows into any asset class are a worrisome sign, there are institutional investors just waiting for corrections in equity and bond markets to plough more money into emerging markets.'"

Japanese 10-year JGB yields jumped 6 bps this week to 1.71%, as the Nikkei 225 index gained 1.4% (up 1.4% y-t-d). Emerging debt and equity markets were generally strong this week. Brazil's benchmark dollar bond yields dropped 17 bps to 6.34%. Brazil's Bovespa equity index gained 3.1% (up 13.7% y-t-d). The Mexican Bolsa jumped 5.0%, with y-t-d gains rising to 8.6%. Mexican 10-year govt. yields fell 10 bps to 5.67%. Russian 10-year dollar Eurobond yields dipped one basis point to 6.71%. The Russian RTS equities index jumped 4.7%, increasing 2006 gains to 25.7%. India's Sensex equities index rose 2.7% (up 15.6% y-t-d).

March 15: Kingdom Holding press release: "Saudi Stock Market Sky Rockets Following HRH Prince Alwaleed's Interview on Al Arabia. After today's 5% drop the stock market recovers with total gain of 10% from its lowest point of the day. The Prince Commended the Efforts of Minister of Finance, H.E Ibrahim Al-Assaf & Mr. Jamaz Suhaimi, President of SAMA..."

Freddie Mac posted 30-year fixed mortgage rates dipped 3 bps to 6.34%, up 39 basis points from one year ago. Fifteen-year fixed mortgage rates slipped 2 bps to 5.98% (up 51 bps in a year). One-year adjustable rates fell 8 bps to 5.37%, an increase of 117 bps over the past year. The Mortgage Bankers Association Purchase Applications Index rose 1.0% last week. Purchase Applications were down 13% from one year ago, with dollar volume 10% lower. Refi applications dipped 1.9%. The average new Purchase mortgage increased to $235,500, while the average ARM slipped to $345,600.

Broad money supply (M3) dipped $2.4 billion to $10.340 Trillion (week of March 6). Year-to-date, M3 has expanded $151.3 billion, or 7.7% annualized. In 52 weeks, M3 inflated $827 billion, or 8.7%. For the week, Currency added $0.3 billion. Demand & Checkable Deposits fell $13.7 billion. Savings Deposits gained $7.4 billion, and Small Denominated Deposits increased $3.1 billion. Retail Money Fund deposits dipped $0.2 billion, and Institutional Money Fund deposits declined $2.3 billion. Large Denominated Deposits jumped $15.4 billion. Over the past 52 weeks, Large Time Deposits were up $262 billion, or 22.6%. For the week, Repurchase Agreements fell $7.6 billion. Eurodollar deposits declined $5.0 billion.

Bank Credit declined $11.2 billion last week to $7.649 Trillion, with a y-t-d gain of $142.7 billion, or 9.9% annualized. In 52 weeks, Bank Credit inflated $651 billion, or 9.3%. For the week, Securities Credit fell $18 billion. Loans & Leases have expanded at a 7.6% y-t-d, and were up 11.6% over the past 52 weeks. Commercial & Industrial (C&I) Loans are expanding at a 13% rate y-t-d, with a 14.3% gain over the past year. For the week, C&I loans declined $2.7 billion, while Real Estate loans jumped $10.8 billion. Real Estate loans have expanded at an 11.0% rate y-t-d and were up 12.6% during the past 52 weeks. For the week, Consumer loans dipped $1.7 billion, while Securities loans rose $6.8 billion. Other loans fell $6.6 billion.

Total Commercial Paper jumped $15.4 billion last week to $1.712 Trillion. Total CP is up $62.6 billion y-t-d (11wks), or 17.9% annualized, while having expanded $261 billion over the past 52 weeks, or 18.0%. Last week, Financial Sector CP borrowings surged $16.8 billion to $1.577 Trillion (up $68.4bn y-t-d), with a 52-week gain of $271 billion, or 20.7%. Non-financial CP dipped $1.4 billion to $135.1 billion, with a 52-week decline of 6.9%.

Asset-backed Securities (ABS) issuance was a "relatively slow" $11 billion (from JPMorgan). Year-to-date total ABS issuance of $151 billion is 5% ahead of 2005's record pace, with y-t-d Home Equity Loan ABS issuance of $106 billion running 11% above last year.

Fed Foreign Holdings of Treasury, Agency Debt ("US marketable securities held by the NY Fed in custody for foreign official and international accounts") rose $3.3 billion to a record $1.595 Trillion for the week ended March 15. "Custody" holdings were up $75.6 billion y-t-d, or 23.6% annualized, and $210 billion (15.2%) over the past 52 weeks. Federal Reserve Credit gained $4.7 billion last week to $820.0 billion. Fed Credit has declined $6.4 billion y-t-d, or 3.6% annualized. Fed Credit expanded 4.4% during the past year.

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - are up $160 billion y-t-d (18.7% annualized) and were up $454 billion, or 12.1%, over the past 12 months to a record $4.206 Trillion.

March 16 - Bloomberg (Halia Pavliva): "Russia's foreign currency and gold reserves, the world's fifth biggest, rose for a 16th consecutive week to a record $201.7 billion... The reserves added $3.8 billion in the week..."

Currency Watch:

The dollar index sank 2.1% this week. On the upside, the Polish zloty jumped 3.5%, the Czech koruna 3.0%, the Swedish krona 3.0%, the Japanese yen 2.8%, the Norwegian krone 2.4%, and the Euro 2.4%. Brazil's real traded to a five-year high this week. On the downside, the New Zealand dollar fell 1.0%, the Australian dollar 0.6%, and the Jamaica dollar 0.4%.

Commodities Watch:

Commodities prices generally came charging back this week, with copper and zinc today trading to new record highs. April crude oil rose $2.81 to $62.77. April Unleaded Gasoline surged 10.2%, and April Natural Gas jumped 6.1%. For the week, the CRB index rose 2.0% (y-t-d down 1.8%). The Goldman Sachs Commodities index jumped 3.7%, reducing the 2006 decline to 0.3%.

Japan Watch:

March 13 - Bloomberg (Lily Nonomiya): "Japan's economy grew at a 5.4 percent annual pace in the fourth quarter, more than economists expected, as manufacturers increased stockpiles to prepare for higher consumer and corporate spending."

March 15 - Bloomberg (Daisuke Takato): "Toyota Motor Corp., Matsushita Electric Industrial Co. and Hitachi Ltd. raised base salaries for the first time in five years, increasing the spending power of Japanese households."

China Watch:

March 15 - Bloomberg (Nerys Avery): "China's industrial production in the first two months of the year rose 16.2 percent from a year earlier as vehicle makers churned out more cars and trucks. Output climbed to 1.11 trillion yuan ($138 billion) after rising 16.5 percent in December..."

March 15 - Bloomberg (Wing-Gar Cheng and Ying Lou): "China, the world's second-biggest energy user, increased oil imports by 34 percent in the first two months of 2006 from a year earlier after the government compensated refiners for selling fuel at below-market prices. Crude oil imports rose to 24.4 million metric tons (3 million barrels a day) in January and February..."

March 15 - Bloomberg (Helen Yuan): "China, the world's biggest producer and user of steel, increased output of steel products 22 percent in February from a year earlier."

March 15 - Bloomberg (Jianguo Jiang): "China's sales of local-currency debt by the government and companies more than doubled in the first two months from a year earlier to 917 billion yuan ($11 billion), the central bank said..."

March 14 - Bloomberg (John Liu): "China's exports of technology products such as computers and semiconductors, increased by more than a third in the first two months of this year, the Customs General Administration of China said. Technology exports rose 37 percent during January and February from a year earlier to $35.8 billion..."

March 13 - Bloomberg (Nerys Avery): "China's trade surplus narrowed to the lowest since July 2004 as rising incomes in the world's most populous nation fueled demand for imported goods. The surplus fell to $2.45 billion from $9.49 billion in January..."

Asia Boom Watch:

March 14 - Bloomberg (Kartik Goyal): "India's exports rose 12 percent in February to $7.8 billion, the commerce and industry ministry said. Imports rose 21 percent to $11 billion in February, widening the trade deficit to $3.2 billion during the month..."

March 14 - Bloomberg (Debarati Roy): "Demand for steel in India may more than quadruple in the next decade... As the government increases investment in railways and ports, steel consumption will rise to 160 million tons from about 35 million tons as the government spends more to develop infrastructure and as economic growth of 8 percent drives use of the metal in houses, cars and appliances..."

March 14 - Bloomberg (George Hsu and Christina Soon): "Taiwan central bank governor Perng Fai-nan said overseas investment into the island's stock market has contributed to more than half its foreign-currency reserves, posing a 'challenge' in stabilizing the exchange rate."

March 13 - Bloomberg (Anuchit Nguyen): "New car sales in Thailand, Southeast Asia's biggest auto market, rose 14 percent in February, reversing January's decline..."

March 14 - Bloomberg (Jason Folkmanis): "Vietnamese exports to the U.S. climbed by more than a fifth in January, led by growth in shipments of apparel, footwear and coffee."

Unbalanced Global Economy Watch:

March 15 - Bloomberg (William McQuillen): "Global economic growth will increase this year by more than the 4.3 percent rate the International Monetary Fund projected in September, said Rodrigo de Rato, the Managing Director of the fund."

March 14 - Bloomberg (Ben Sills): "Underlying inflation in Spain, Europe's fifth-largest economy, held in February at its fastest rate in 33 months... The underlying inflation rate, which excludes the price of energy products and fresh fruit, held at 2.9 percent..."

March 17 - Bloomberg (Evalinde Eelens): "Dutch retail sales rose in January at the fastest pace since July 2002, led by clothing sales, a sign that economic growth is recovering after a slowdown last year. Retail sales grew an annual 5.6 percent, while the volume of sales also rose 5.6 percent, the Voorburg-based Dutch statistics bureau said on its web site today. Prices advanced 0.1 percent from a year earlier."

March 16 - Bloomberg (Fergal O'Brien): "Irish retail sales increased in January at the fastest pace in six years, boosted by demand for automobiles... Sales increased 9 percent from a year earlier."

March 13 - Bloomberg (Tracy Withers): "New Zealand house prices rose 15.3 percent in February from a year earlier, slowing for the first month in three..."

Latin America Watch:

March 16 - Bloomberg (Patrick Harrington): "Mexico's industrial output grew the most in 15 months in January, led by a surge in auto production. Industrial output rose 6 percent in January [y-o-y]...after increasing 2.7 percent in December..."

March 16 - Bloomberg (Daniel Helft): "Argentina's economy grew 9.2 percent in 2005, the fastest pace in 13 years, as demand for goods surged from salary increases and record exports."

Bubble Economy Watch:

The fourth quarter Current Account Deficit came in at a record $224.9 billion, an unprecedented 7% of GDP. In a sign of things to come, the difference between what American earned on overseas investments fell $2.4 billion short of the income earned on U.S. assets by foreigners. The 2005 Current Account Deficit was a record $805 billion, up 30% from 2004 and double 2001.

The February Consumer Price Index was up 3.6% y-o-y. February Import Prices were 7.4% higher than a year ago. New York Fed index jumped to the highest level since July 2004. At (stronger-than-expected) 2.12 million annualized, February Housing Starts remained robust. Continuing Claims for unemployment dropped to 2.445 million, a low since February 2001. While down from booming January, February Retail Sales were up 6.5% from January 2005, with Retail Sale Ex-Autos up 8.8% y-o-y.

March 15 - The Wall Street Journal (Kemba J. Dunham, Thaddeus Herrick and Jennifer S. Forsyth): "Despite signs of a housing-market slowdown, the number of areas in the U.S. rated as 'extremely overvalued' continues to climb. And in addition to the usual suspects on both coasts, some peripheral markets are getting more pricey. According to Global Insight/National City's quarterly housing valuation analysis, 42% of the U.S. housing market was overvalued and at risk for a price correction during the fourth quarter of 2005. The study analyzed 299 metro areas in the U.S, which account for 76% of all single-family housing units. The number of extremely overvalued markets increased to 71 from 61 in the third quarter."

March 14 - Bloomberg (Tom Becker and Patricia Hurtado): "U.S. bankruptcy filings rose 10 percent in 2005 to a record 1.78 million, fueled by a more restrictive law that went into effect October 17th. Business filings surged about 20 percent in the third quarter before the law changed. For the year, business filings fell 2 percent to 34,220... About 542,000 filings were made in the third quarter, the most ever in a single quarter..."

March 15 - Bloomberg (Martin Z. Braun): "A New York City economic development agency granted the Yankees and Mets major league baseball teams approval to finance new stadiums with $1.56 billion in tax-exempt and taxable bonds."

March 16 - The Wall Street Journal (David Wessel): "Write about inflation, and readers are quick to complain that the U.S. government's consumer-price index fails to capture the reality of rising prices. 'If you did your own personal study of inflation in your neighborhood ...where you shop, you would be appalled at how much prices go up without being reported as inflation,' Reggie Marselus emailed from Lenexa, Kan. 'Government inflation figures are the most bogus numbers reported in the entire economic world.' The Bureau of Labor Statistics releases the latest CPI this morning. Forecasters say a drop in gasoline prices in February will keep the monthly increase in the CPI to a comfortable 0.1%, though that still is a sharp 3.7% above a year ago... Americans coping with rising health-insurance premiums, or paying college or private-school tuition bills, or trying to buy a house, look at those numbers and scoff."

Mortgage Finance Bubble Watch:

Countrywide Financial posted mixed results for February. The Total Pipeline rose about $2 billion to $59.3 billion, while Total Fundings declined $1.4 billion from January to $31.2 billion. Fundings were up 15% from January 2005, with Purchase fundings up 12% and Non-purchase (refi) up 17%. ARM fundings increased 17% from a year ago. Home Equity fundings were up 30%, and Subprime gained 9%. Bank Assets were up 71% from a year earlier to $78.7 billion.

March 15 - Los Angeles Times (Annette Haddad): "Southern California home prices returned to their record ways last month, but the number of sales declined as the region's housing market continued its shift from red-hot to lukewarm... In February, the median home price in the six-county region reached a record $480,000, up 12.9% from a year earlier. Last month's figure also represented a turnaround from January, when the median fell 2.1% to $469,000... But the number of homes sold in February, 19,905, was the lowest in five years, research firm DataQuick...said. Across the region, sales declined 7% from a year earlier and 0.9% from January."

March 14 - Dow Jones (John Connor): "Fannie Mae said housing goals set by the Department of Housing and Urban Development will continue to challenge the firm and may lead it to increase its investments in higher-risk mortgage products that are more likely to serve borrowers targeted by HUD but that could increase its credit losses."

Fiscal Deficit Watch:

March 17 - Bloomberg (Tony Capaccio and Jeff Bliss): "U.S. military spending in Iraq and Afghanistan will average 44 percent more in the current fiscal year than in fiscal 2005, the nonpartisan Congressional Research Service said. Spending will rise to $9.8 billion a month from the $6.8 billion a month the Pentagon said it spent last year..."

March 15 - Dow Jones: "The rising cost of healthcare provision could 'swamp' the U.S. government, U.S. Comptroller General David Walker said... Speaking at the London School of Economics, Walker also warned that the federal government's budget deficit is 'imprudently high' and added that its financial position is weaker than it will admit."

March 17 - Bloomberg (Ryan J. Donmoyer): "U.S. Comptroller General David M. Walker said the nation's business community is 'missing in action' in the fight for fiscal responsibility in Washington and needs to prepare for the 'demographic tsunami' caused by the retirement of the baby boom generation. Walker rejected as 'just flat false' the assertion that the deficit is caused largely by spending on Iraq, Afghanistan and homeland security, one often made by the Bush administration. He said many Americans are ignoring deep-seated fiscal problems out of a 'false sense of security' generated by a relatively healthy economy and that business leaders are silent because of a combination of 'myopia,' preoccupation with corporate problems and aversion to political controversy."

Speculator Watch:

March 13 - Bloomberg (Adrian Cox): "Wall Street's top five chief executive officers, led by Goldman Sachs Group Inc.'s Henry Paulson, raked in more than $151 million last year after leading their firms to record profits."

Earnings Watch:

March 15 - Dow Jones: "The earnings of companies in the Standard & Poor's 500 stock index that have issued fourth-quarter reports are running 14.8% higher than year-earlier results, according to Thomson First Call. Of the 500 companies, 486, or 97%, have reported earnings for the quarter as of Tuesday... Compared with a year earlier, earnings of S&P 500 companies are expected to rise 14.5% in the fourth quarter."

Goldman Sachs' (blowout) first quarter Total Revenues were up 73% from Q1 2005 to $17.246 billion (Net Revenues - reduced by Interest Expense - were up 61% to $10.34bn). "Investment Banking produced net revenues of $1.47 billion, its second best quarter and its best quarterly performance in nearly six years. Fixed Income, Currency and Commodities (FICC) generated record quarterly net revenues of $3.74 billion, 42% higher than its previous record... Net Revenues in Trading and Principal Investments were $6.88 billion, 57% higher than the first quarter of 2005 and 68% higher than the fourth quarter of 2005... Equities produced record quarterly net revenues of $2.45 billion, 33% higher than its previous record set in the first quarter of 2001, reflecting strength across all major businesses and regions. Asset Management generated record quarterly net revenues of $1.49 billion... (Asset Management) Net Revenues were 89% higher than the previous record." Net Earnings were up 62% from a year ago to a record $2.453 billion. Compensation expenses jumped 66% to $5.301 billion. Goldman ended the quarter with a M&A backlog of $538 billion and Assets Under Management of $571 billion. The company repurchased 19.1 million shares of stock during the quarter at a cost of $2.58 billion.

Lehman Brothers reported much stronger-than-expected first quarter Net Income of $1.069 billion, up 25% from the year ago period. Total Revenues were up 40% to $10.31 billion. Company highlights included, "Achieved record net revenues in every segment and in every region." Compensation expense was up 18% from a year ago to $2.199 billion. Lehman repurchased 7 million shares of stock during the quarter. Total Assets surged $29.5 billion during the first quarter, or 29% annualized, to $439.5 billion. Total Assets expanded at a 29% pace over the past two quarters, were up 20.8% in the past year and surged 34.0% over two years.

Bear Stearns reported better-than-expected first quarter Net Income of $514 million, up 36% from Q1 2005. Total Revenues were up 39% to $3.64 billion. "Institutional Equities net revenues were a record $488 million, up 56% from $313 million for the first quarter of 2005. Equity derivatives delivered a second consecutive record quarter... Fixed Income net revenues were a record $889 million, up 3%... Investment Banking net revenues were $297 million...up 36%... Wealth Management net revenues...were a record $223 million, in an increase of 32%...

A Response to Donald Kohn on Asset Bubbles:

Federal Reserve Governor Donald Kohn yesterday presented his views on "Monetary Policy and Asset Prices," at a conference in Frankfurt: "Monetary Policy: A Journey from Theory to Practice," a European Central Bank Colloquium held in honor of Otmar Issing. Interestingly, he took the opportunity to clarify the Fed's view of managing asset inflation and Bubbles, one that contrasts markedly from those of the retiring Otmar Issing and the ECB. No issue is today more critical to central bank policymaking.

From Dr. Kohn's speech:

"Most fluctuations in stock prices, real estate values, and other asset prices pose no particular challenge to central banks, as they are just some of the usual factors influencing the outlook for real activity and inflation. But many argue that pronounced booms and busts in asset markets are another matter, especially if actual valuations appear to be misaligned with fundamentals. What should a central bank do when it suspects it faces a major speculative event--one that might be large enough to threaten economic stability when it unwinds? To help frame the discussion, I will focus on two different strategies that have been proposed for dealing with market bubbles."

The first approach--which I will label the conventional strategy -- calls for central banks to focus exclusively on the stability of prices and economic activity over the next several years. Under this policy, a central bank responds to stock prices, home values, and other asset prices only insofar as they have implications for future output and inflation over the medium term. Importantly, the strategy eschews any attempt to influence the speculative component of asset prices, treating any perceived mis-pricing as, rightly or wrongly, an essentially exogenous process. Following this strategy does not imply that policymakers ignore the expected future evolution of speculative activity. If policymakers suspect that a bubble is likely, say, to expand for a time before collapsing, the implications of that possibility for future output and inflation need to be folded into their deliberations. Practically speaking, however, I view our ability to act on such suspicions as limited given how little we know about the dynamics of speculative episodes."

"Despite its approach to perceived speculative activity, the conventional strategy does recognize that monetary policy has an important influence on asset prices--indeed, this influence is at the heart of the transmission of policy decisions to real activity and inflation. It occurs through standard arbitrage channels, such as the link between interest rates and the discount factor used to value expected future earnings.

"The second strategy, by comparison, is more activist and attempts to damp speculative activity directly. It was described at length in 'Asset Price Bubbles and Monetary Policy,' an article published by the ECB last year. I quote from the article: 'This approach amounts to a cautious policy of 'leaning against the wind' of an incipient bubble. The central bank would adopt a somewhat tighter policy stance in the face of an inflating asset market than it would otherwise allow if confronted with a similar macroeconomic outlook under more normal market conditions. . . . It would thus possibly tolerate a certain deviation from its price stability objective in the shorter term in exchange for enhanced prospects of preserving price and economic stability in the future.' I am labeling this second approach extra action, as it calls for steps that would not be taken in ordinary circumstances."

I have, for some time, strongly objected to the Fed's shallow analytical perspective and complacent stance with respect to Asset Bubbles. It is my view that the contemporary approach to analyzing the highly complex interplay between monetary policy, Credit system dynamics, asset prices and economic activity/development is dangerously flawed. When it comes to recognizing and investigating Asset Inflation and Bubbles, the fundamental focus should be with Credit Growth and Speculative Dynamics - the nature and prevailing course of the underlying Credit mechanism generally. The Fed seems to go out of its way to avoid this fruitful analytical framework.

At its core, the Fed has fashioned a Strategy of Asset Inflation and Bubble Acquiescence, with the stipulated policy objective of orchestrating aggressive "mop up" exercises come the inevitable onset of bursting. Admittedly, this approach appears today - at the exuberant blow-off phase of multi-decade Credit and Leveraged Speculation Bubbles - all-together reasonable and even, perhaps, brilliant policy. It is most definitely neither. The bottom line is that such a "benign neglect" approach to Bubbles continues to play an instrumental role in nurturing their expansion and course of development.

I certainly disagree with Dr. Kohn's assertion that the Fed's approach is less activist than the ECB's 'leaning against the wind of incipient Bubbles.' Unsound booms inevitably go bust, and it is the Fed's manifest determination to employ inflationary policies (to sustain the boom) is tantamount to The Ultimate in Activist Central Banking. The Fed wants it both ways: It embraces the manipulation of financial profits/incentives and asset prices as 'at the heart of the transmission of policy decisions to real activity and inflation," yet it is content to operate in an asymmetrical analytical and policy vacuum with respect to inevitable excesses and consequences. If anything these days is apparent to the discerning, it is that it is paramount that Bubbles be recognized and restrained as early as possible, while if a central bank provides assurances that markets will remain liquid and buoyant, speculation and resulting Asset Bubbles will be cultivated to unmanageable excess.

Dr. Kohn writes, "if actual valuations appear to be misaligned with fundamentals." I've always believed that "valuations" and "fundamentals" are too amorphous and ambiguous and, hence, should be relegated to peripheral status when it comes to Bubble analysis. For one, they are very much in the eye of the beholder and will surely be interpreted through a bullish perspective during a boom (when it is critical to contain Bubble proclivities). More importantly, I argue that a Credit-induced boom will invariably manifest positive "fundamentals." To be sure, an inflated flow of finance (divergently boosting corporate earnings, government receipts, economy-wide "cash"-flows, household income, perceived wealth, debt/asset value ratios, and Credit scores) will positively impact asset valuations generally (not to mention incite a binge of "animal spirits," investment and technological advancement). Case in point: For those with the persuasion that the Roaring Twenties was the golden age of economic advancement and monetary management, the stock market's 1929 price-to-earnings ratio of 12 patently disproves any notion of an equity market Bubble.

From Dr. Kohn: "As the ECB article notes, extra action is often seen as a type of insurance. And as with any insurance policy, before you buy you have to ask whether the expected benefits outweigh the costs. As I see it, extra action pays only if three tough conditions are met. First, policymakers must be able to identify bubbles in a timely fashion with reasonable confidence. Second, there must be a fairly high probability that a modestly tighter policy will help to check the further expansion of speculative activity. And finally, the expected improvement in future economic performance that would result from a less expansive bubble must be sizable."

My retort is that these comments go right to the heart of the dilemma: Containing Asset Inflation and Bubbles (especially in the contemporary age of unchecked finance) is a prerequisite for general long-term financial and economic stability - and it is thereby inappropriate to analyze this issue in the context of the potential costs and benefits of "insurance." The costs associated with a runaway Bubble are much too great to so readily discount and dismiss. Moreover, I strongly doubt that these "three tough conditions" would ever be satisfied, recognizing the nature of the highly impressionable boom-time mindset. And, let's face it, if these conditions can't be met today, they never will. The Fed couldn't at the time see the conspicuous tech/telecom debt Bubble with "reasonable confidence;" they've remained blind to the Great Mortgage Finance and Housing Bubbles; and they don't appear on the cusp of pinpointing the evolving Unparalleled Global Liquidity and Asset Bubble.

Effective Asset Inflation and Bubble policymaking requires a clear policy framework, determination and discipline. In this regard, a focus on the quantity and character of Credit expansion is fundamental. A central bank will never have sufficient knowledge and understanding to assure "a fairly high probability that a modestly tighter policy will help to check the further expansion of speculative activity." A major issue today is that system leveraging and speculative excess have been nurtured to the point of creating acute financial fragility, thus restricting perceived policy options.

Central bankers will never fully anticipate the degree of restraint required to check excesses. It is at the same time crucial for long-term system stability to retain the capacity to mete out significant pain when necessary. Never should policymakers fall into the quagmire of having lost the wherewithal to remove the "punchbowl." And Dr. Kohn's third criterion, well, it makes no sense to me. It is impossible to quantify and measure, let alone forecast, the long-term "improvement of economic performance" in a post-Bubble environment. Even it were practical, how would we then weigh this metric against the unknowable future direction, risks and consequences of evolving financial and economic systems when asset inflation and Bubbles are accommodated and allowed to run unchecked?

From Dr. Kohn: "Consider the U.S. stock market boom of the mid-to-late 1990s. The boom was fueled by a sustained acceleration of productivity and an accompanying rise in corporate profits--fundamental changes that justified a major rise in equity prices."

Productivity gains do not fuel booms, although booms might very well spur heightened productivity. Instead, booms are driven by Credit growth, of which there was over-abundance throughout the second half of the nineties. It is worth noting that many of the companies demonstrating the most outstanding "fundamentals" - surging profits and stock prices - saw both abruptly vaporize during the bursting of the Bubble. The boom had all the appearances of a miracle, that is up until the massive speculative flows (liquidity) inundating the technology sector reversed and triggered collapse.

From Dr. Kohn: "Again, consider the U.S. experience of the late 1990s. When the FOMC tightened in 1999 and early 2000, the trajectory of stock prices actually steepened, and equity premiums fell--perhaps because investors became more confident that good macroeconomic performance would be sustained. Since mid-2004, we have seen a marked decline in bond-term premiums, even as the funds rate has risen steadily. These episodes illustrate that risk premiums often move in mysterious ways, and we should not count on the ability of monetary policy to nudge them in the intended direction."

Well, 1999 certainly doesn't provide an untainted laboratory for which to draw conclusions. Let's not forget the momentous bout of Credit and speculative excess unleashed the previous autumn when the Fed bailed out LTCM and (along with the GSEs) reliquefied the Credit system. Of course 1999 rate increases were going to dictate a much less restraining influence on Wall Street Finance and the leveraged speculator community after the Fed had just made it unequivocal that it was willing and able to guarantee liquidity and support the markets. As 1999 unfolded and market perceptions evolved, the liquidity and speculative backdrop became so extraordinarily loose that the manic reaction to the wildly inflating technology Bubble was impervious to moderate rate increases. It was too late; the Fed had missed its timing.

Similarly, the recent unparalleled loose global liquidity and speculative backdrop - and resulting Asset Inflation - was simply not going to be checked by Fed "telegraphed baby-steps." Just look at Wall Street's earnings reports; it's pedal to the metal. And I would further argue that spreads are these days chiefly an indication of perceived prospects for general marketplace liquidity and Credit Availability, of which the markets perceive the Fed will underwrite aplenty.

From Dr. Kohn: "A monetary easing directed at stabilizing output and inflation might, conceivably, drive up real estate values by more than fundamentals alone would merit. Still, you would expect any mis-pricing from these sources to be reversed over time as interest rates returned to normal."

At this point, it seems rather clear to me that the greatest cost associated with accommodating the leveraged speculation and technology Bubbles during the nineties was that any inflationary "mop up" policy response virtually guaranteed that Bubble Dynamics would take hold throughout mortgage finance and then, disseminated through massive Current Account Deficits, beyond to the world. And, importantly, it is a formidable misconception to presuppose that any real estate (or other asset class, for that matter) "mis-pricing" would be reversed as interest rates were returned "to normal."

A major Credit inflation - of which the Mortgage Finance Bubble has been one of historic magnitude - has the potential to profoundly alter entire Credit system dynamics and the nature of financial intermediation, in the process radically distorting the flow of finance throughout both the Financial and Economic Spheres. The upshot will be a fundamental and highly unstable inflationary recasting of asset prices, right along with financial and economic profits, incomes and relative prices generally (Monetary Disorder). Once unleashed, it is wishful thinking for a central bank to contemplate controlling the process (become hostage to it, sure).

I would argue that the notion of interest-rate normalization achieving a reversal of mis-pricing is dangerously flawed. More likely, a significant mis-pricing - the consequence of a Credit induced inflation of a major asset class - begets only greater pricing and economic distortions.

From Dr. Kohn: "Proponents of extra action often cite an increased risk of severe financial distress as a potential source of such effects. However, without the onset of deflation, how large is this risk? In recent history, the health of the U.S. financial system remained solid after the collapse of the high-tech boom, despite the bankruptcy of dozens of telecom and dot-com firms, the loss of more than $8 trillion in stock market wealth, and stress in the nonfinancial corporate sector."

This is where the Fed skates on especially thin ice. Household Debt expanded 8.6% in 2000, 8.6% in 2001, 9.7% in 2002, 11.4% in 2003, 11.1% in 2004, and 11.7% last year. After slowing to 4.8% in 2000, Total Non-Financial Debt expanded 6.1% in 2001 and growth accelerated each year to 2005's blistering 9.5%. One would expect the financial system and economy to demonstrate robustness during such a bout of unparalleled Credit expansion. But is it sustainable? What is the endgame? And, "without the onset of deflation, how large is the risk?" Well, I've for some time argued that the issue is not "deflation" as much as it is the risk of debt crisis and collapse.

From Dr. Kohn: "I do agree that market corrections can have profoundly adverse consequences if they lead to deflation, as illustrated by the United States after the 1929 stock market crash and the more recent experience of Japan. But it does not follow that conventional monetary policy cannot adequately deal with the threat of deflation by expeditiously mopping up after the bubble collapses. In Japan, deflation could probably have been avoided if the initial monetary response to the slump in real estate and stock market values had been more aggressive... As for the Great Depression, the Federal Reserve actually worsened the situation by allowing the money supply to contract sharply in 1930 and 1931, after unwisely attempting to prick the stock market bubble in the first place. Rather than demonstrating the need for preemptive extra action to restrain emerging bubbles, these examples are object lessons concerning the wisdom of central banks' easing promptly and aggressively following market slumps when inflation is already low, so as to head off the threat posed by the zero lower bound. By doing so, policymakers should be able to avoid the severe nonlinear dynamics of deflation."

Ironically, the Fed's Strategy of Bubble Acquiescence and "Mopping Up" - redressing each deflating Bubble with a larger and more comprehensive one - is precisely the prescription for the type of Unmanageable All-Encompassing Credit Bubble that virtually ensures Systemic Currency and Debt Crisis - at some point. And, to be sure, the global nature of recent Credit and speculative excess, along with sweeping and indiscriminate Asset Inflation, creates precarious Bubble underpinnings: the more extreme the excesses; the greater the vulnerability to financial dislocation; the more timid the policymaker - and the more indomitable the speculative impulses within a community that has never made so much "money" with such ease.

As I believe we witnessed this week, extraordinarily speculative global financial markets took comforted from inferences of a lack of nerve from the Fed and the Bank of Japan. Global bond markets (generally) abruptly retraced some of recent declines, spurring the resurgence of global equity market speculation (and short covering). Currency markets vacillated, the dollar index was hit for 2%, and the energy and metals complexes rallied back smartly. Middle Eastern equity Bubbles lurched toward collapse then retreated. All in all, it has the look and feel of a major topping process, as players assess and reassess the prospects for a continuation of, or destabilizing interruption to, the Global Credit and Asset Bubbles.

I can imagine that the Fed today takes comfort from its amassed war chest of 450 basis points of reflation ammo. But the enemy is often not as anticipated. There's a critical issue of which I am left unclear. How does "mopping up" - or perhaps better stated, what is to be "mopped up" - in the middle of a currency crisis?


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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