Thoughts re a simple QE model of asset price bubbles…assorted recent tweets

I was thinking along similar lines..but if debt amplifies interest rate increases, what on earth is a neutral IR policy?

Why is raising interest rates currently a greater risk than usual?  Not just highly priced asset markets but significant levels of debt and an increasing amount of new debt issuance in lower credit quality assets.   In proportion to GDP growth, debt and asset levels are at historically high levels.  A given amount of economic return is spread much more thinly over a much wider range and supply of assets and hence the impact of interest rate increases are much more highly leveraged.  Understandably we needed to support asset prices during the abyss that opened up late 2008 to early 2009, but I am much less sanguine about monetary support 2011 onwards.

Models are very important..stepping into them more does modern economics model impact of asset bubbles of last 2.5 decades?

Where is Fed QE model? QE flows should be replaced by output growth flows (input) + need to see wealth effect expenditure (output)…measurable

This deals very much with comment 1. I do not see much analysis or insight into the dynamics of high debt levels/high asset prices and the impact of such dynamics on economic stability, especially where we have continuing asset price support and soupcons of interest rate increases over the horizon.  From what I read, individuals like Dallas Reserve Fed Chair Fisher aside, the Fed itself does not see much evidence of bubbles, except in small areas of the market.  So there is no real assessment of the risks of the considerable asset focussed monetary expansion of the last 2 decades or more.  I think this is perverse.  It is almost as if this QE excess is an isolated incident, when in fact it is yet another layer added to the many layers already built into our economic and financial fabric.

Weight of excess asset valuation (Debt+equity) holding IRs captive..sustained QE created greater IR sensitivity

Asset focus of broad MS over last 2+decades create difficulty for IR increases: IR impact on econ leveraged by asset bubble

Re IR increases: excess asset focus of MS dwarfs the economic..assets leveraged around econ structure..any IR effect multiplied..catch22

As noted in a previous post, the higher the asset valuation and the greater the supply of assets relative to future growth in output, the more sensitive the value of assets to changes in interest rates.  This is especially the case where we have had a period of sustained quantitative easing ….Until Dec 2013 the Fed was buying up $85bn of securities a month (before coupon reinvestment), or $1,020bn a year compared to personal saving of some $561bn a year (BEA table 2.6).   A 1% interest increase is going to have a different consequence the larger the amount and valuation of assets in the market place, so we need some assessment of the relative sensitivity of the financial system/economy to interest rate increases in the current environment.  It is possible that we have come so far down this QE road that raising interest rates may by any meaningful measure may not be realistic.  

IR increases should not target econ but excess asset focussed MS..problem is excess has accumulated over time

Interest rate increases are likely needed to stem the transmission of excess liquidity into the issuance of higher risk/less liquid asset classes.   But interest rate increases are clearly not needed to stem economic excesses at this present point in time even though I believe that the real economy could accommodate higher interest rates, probably a discount rate in the range of 2%.   The problem as noted is the accumulation of debt and rises in asset prices.  It is difficult to see how IRs can be raised without impacting the economy. 

Do the central banks even possess models that assess impact of bubbles on IR transmission and impact on econ? 

More I read, more concerned over systemic failure to understand dynamics of decades of excess asset focus on econ stability..cogs have impact

There are an increasing number of for and against a bubble articles and blog posts that you do wonder whether or not the lessons of the last and in truth continuing crisis have been learnt.  I believe that we remain in a large asset focussed money supply bubble and that the recovery that has accompanied QE has justified to many an assumption that bubbles are temporary and can be overcome.  I think they are long lasting and very difficult to deal with.

Wall of worry different from previous cycles where demand flows from uncertain marginal changes in savings/MS/portfolio reallocation..#QE too big to ignore

I see some pundits pointing out the fact that there is too great a weight of concern over asset price bubbles for there to actually be an asset price bubble.  I think the large increase in money supply has resulted in very large increases in portfolio cash holdings that make the present wall of worry argument vastly different from the past.  Historically trying to work out whether demand was slowing or growing, whether people would be putting more into stocks or bonds made it virtually impossible to know what was going to happen to the market at any given point in time.   Nowadays structural and certain elements such as the vast increase in portfolio money holdings have a much bigger sway on markets.  The mechanics of structure and hence worry have changed and that is why it is dangerous to rely on rules of thumb and other behavioural heuristics.

Ignores forces acting on object…recession not the drag but effect…Escape velocity is from debt/income inequality/global structural imbalances

My comment was with regard to escape velocity, or the rate of economic growth that would allow the economy to finally extricate it from the previous recession and the ever present risk of recession.   My point was that the recession itself was not the drag on growth but the structural baggage that built up prior to the recession, much of which still exists today.   These are issues from which you cannot really escape without properly addressing.  

In 2000 felt Greenspan’s legacy going to be critical of IR market support..think same with #QE..beyond rationale point

I believe that QE has gone beyond the task of supporting asset prices, at a critical juncture (2008/2010), and re-establishing confidence in markets and the financial system.  Instead it has bred a false sense of security and far too great a focus on asset prices.   Real economic issues underpinning the frailty have been largely ignored.   Have we created a monster in the Frankenstein mould?

Obvious: #QE a monetary flow to asset prices;wage growth key to replacing flow;QE=synthetic wage growth compression with wealth effect.

Income growth is a key flow into QE model as it rewinds…from income comes saving/expenditure..saving key flow supplanting QE

In a healthy economy output provides the income that supports consumption investment and production and the savings that go to prop up the asset markets…output flows to assets and then from assets to consumption.  QE is designed to synthetically imitate a higher level of output growth and therefore a higher level of income growth on assets and asset related consumption.  

A critical theme:#QE creating stress between asset price growth imperatives and fundamental growth realities;differential expanding at incr. rate

The more assets we accumulate and the higher their price and the greater the divergence between their rate of growth and the growth rate of the economy that finances their values the greater the stress between the two…  The difference between the growth in the value of assets (price x supply) and the value of GDP growth is continuing to expand.  While the growth rate of the expansion is not increasing the overhang itself is.  I believe that the size of the difference between the two is an indicator of stress and structural imbalance.

Point re great moderation has merit – QE+low IRs created stress between asset price imperatives & growth expectations

This was in response to a recent Schiller piece at Project Syndicate.  There is a continuing argument between economists about trend growth before and after the crisis, some arguing that we are in secular stagnation others that monetary policy was the cause of the recession and the output gap. 

My concern is this: QE seems to be predicated on a higher GDP growth expectation than many in the secular stagnation and structural issue camp.  So we have asset prices being pushed up to get economic growth back to a higher trend when the economy may be incapable of reaching that trend.  Not only is QE creating a potentially dangerous synthetic compression of GDP demand flows (see previous comments in the post) as well as high market valuations, but it may also be based on incorrect growth expectations.   So the risks of the policy are real and if my analysis is correct this inappropriate application of policy has created not just an adjustment shock, as QE slides out of use, but a demand shock, an additional crisis, that would not necessarily have been priced into the economic fabric.  A double whammy?

IMF #QE prescription: replace current debt deflation risks with future debt deflation risks.. a straight swap …

IMF: “risk-taking/credit growth… not immediate risk..not next to..too low inflation,” ..but future debt deflation?

The IMF seems to be suggesting that QE is a swap…swapping current debt deflation risks with future ones in the hope that when these additional burdens come home to roost that the economy is stronger.

#QE : either not working and asset price accommodation’ adjusted or it is and the same as output/demand growth transmission set to impact all prices

You cannot have your cake and eat it.  If QE has worked and the economy is recovering then the important transmission mechanism impacting asset prices from output growth is set to double up on low IRS and accumulated money supply. An asset price shock is likely as interest rates rise to head off inflationary consequence.  And if QE is not working then the gulf between actual GDP growth and that expected by asset prices is likely to cause an asset price shock.

It’s about distortions+consequences of distortions. For QE to work need income growth with gdp growth, saving+consumption of assets

But have had too much in rising asset price area+ increasing amount in credit/debt issuance sphere.QE risks are building.

We need to remember that QE is about distortions, either distortion in important economic relationships that have impacted growth or the creation of distortions in asset prices to overcome fundamental economic constraints.  QE risks are building.  We are in the midst of massive modern monetary experiment that is involved in building a different perception of reality through asset prices.

I think we need to realise that QE has put Fed policy in a straitjacket…it cannot fail until it has succeeded

If it has built asset prices up and growth has not recovered sufficiently, it cannot exit without risking an asset price shock and all the secondary liquidity ramifications to the shadow market and mainstream banking system.

With QE, policy objectives Fed more dimensional than unemployment – output flows to/support and from assets, i.e.wealth expenditure, key

My point here is that the Fed’s objectives are more than just employment levels given that QE is all about flows, issues like income growth are key objectives of policy.  QE has made Fed policy much more dimensional.

Doubts over risks of QE inspired asset prices ignore important risk of failure + relevance of policy in 1st place

omits large increase port money allocation/QE bond purchases/corp share buybacks/high yield+leveraged loan issuance/EM credit growth..

Missing debt+expected output growth side of equation – simple model, all else same, decline in IRs = higher PVs, but is all else=?

I must admit I had to disagree with a blog post on asset valuations.   It doubted that prices were overvalued which was at odds with the risk of failure of QE and the relevance of the policy in the first place.  QE is designed open up distance between an economic fundamental valuation of assets and a QE based valuation of assets.  If the price differential did not have risk then it would have no value.

Asset prices a function of money supply+MS growth+change supply of assets+preferred portfolio holding of money as % of a) MS holdings b) asset portfolio

There are three things that define asset prices: money supply growth, because this impacts demand for both assets and output; change in the supply of assets and note that both supply of assets and MS can increase in the case of residential mortgages; changes in the preferred allocation of money between expenditure and assets and within assets to the preferred allocation of money within a portfolio.

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