Asset prices could push central bankers off course long before any bubbles burst

THE post-crisis challenge for central bankers has long seemed easy to describe. They must steer between the shoals of short-term deflation and the longer-term risk of accelerating consumer prices. But recently a new concern has cropped up: that loose monetary conditions are creating dangerous bubbles in all manner of assets, from oil prices to Asian apartments, that could capsize the global recovery.

Asset prices have certainly risen impressively. The S&P 500 index is up by 62% from its low on March 9th; the MSCI index of emerging-economy shares has climbed by 114% from its nadir of a year ago; the price of oil is 155% higher than it was in December 2008. Gold prices set a new record of over $1,120 an ounce on November 12th . Chinese house prices rose at their fastest pace in 14 months in October.

However, these rebounds have followed even more dramatic slumps, so asset-price levels are less eye-popping. Gold apart, commodities are still well below the peaks of mid-2008. The earnings multiple for Shanghai’s A-share index is less than half the level it reached during the 2007 bubble. American shares may be richly valued relative to earnings, but they are less unhinged than in earlier booms. According to Smithers & Co, a research firm, the price-earnings ratio for America’s S&P 500 on a cyclically adjusted basis is about 40% above its long-term average, compared with over 100% in the late 1990s.

There are other reasons for calm. Earlier this year investors were in panic mode. Much of the rebound since then reflects a return to more normal risk appetites. Nor is today’s asset boom fuelling the kind of leverage that made the bust so awful. Bank lending is contracting in America and weak elsewhere in the rich world. In Asia, property-related borrowing is heavily curtailed compared with America’s pre-crisis boom. And from Singapore to Seoul, the authorities are demanding higher down-payments from borrowers and restricting lending to developers.

Nonetheless, it would be a mistake to be too sanguine. Another violent drop in share prices could have disproportionate effects on confidence and hence demand. Equally important, frothy asset prices could cause damage long before any bubbles burst, by increasing the risk that central bankers make mistakes.

Capital inflows

This risk is most obvious in those countries—mostly emerging markets—where domestic conditions call for tighter monetary policy. China is Exhibit A. With a vigorous domestic recovery under way, China ought to tighten soon, before asset prices bubble out of control. But China is loth to allow the yuan to appreciate rapidly. And it will not be pressured by high consumer-price inflation, as it was in 2008. Thanks largely to soaring pork prices, China’s annual inflation rate reached almost 9% early that year. Today it is negative and few expect consumer prices to rise by much more than 3-4% in 2010.

Asset-price rises are also a problem for emerging economies with flexible exchange rates. Many have seen their currencies soar as foreign money pours in. Raising interest rates to tighten domestic monetary conditions can attract yet more foreign money. Increasingly countries are turning to controls on capital inflows. Brazil has already introduced a 2% tax on foreign portfolio investments to stem the rise in the real. On November 10th Taiwan banned foreign investors from putting money into Taiwanese fixed-term deposits. More such measures are likely, increasing the chance of distortions.

In weak, rich economies the danger is not too little too late, but too much too soon. Jumps in asset prices risk causing premature inflation jitters. Oil prices, especially, pose a danger. In recent months year-on-year headline inflation rates in most of the world’s big economies have been negative, largely because oil prices have been far below the heights of mid-2008. That is about to change dramatically, as the slumping oil prices of late 2008 and early 2009 affect the comparisons.

In America headline consumer prices fell by 1.3% in the year to September. By December they could be up by 3%. Even if oil prices stay around $80 a barrel, these “base effects” could keep America’s headline inflation above 2% for much of the first half of 2010. Many expect commodity prices to continue rising. Analysts at Goldman Sachs expect a barrel to cost $95 by the end of next year. Long-dated futures contracts are now flirting with the $100 mark.

An energy-driven headline inflation rate of 3% hardly spells disaster. Core inflation, which strips out jumpy food and fuel prices, is low, at 1.5%, and falling, thanks to the huge amount of slack in the economy. With a jobless rate of 10.2% and oodles of idle capacity, America still faces a bigger threat from deflation than from inflation.

The risk of asset prices

The risk is that higher headline inflation is misinterpreted as a sign that policy is too loose. Judged by the “breakeven” rate between inflation-protected and other Treasury bonds, financial markets’ estimates of long-term inflation have jumped of late, although consumers’ expectations have remained stable (see chart). Worries about the size of America’s budget deficit and fears about the potential politicisation of the Federal Reserve are rising. (A proposal released this week by the Senate Banking Committee which strips the Fed of supervisory powers and introduces political appointments to the regional reserve-bank boards hardly helps). There is a danger that higher headline inflation will be misread, even as rising energy costs sap demand.

Vince Reinhart of the American Enterprise Institute worries about a replay of the summers of 2007 and 2008. On both occasions a weaker dollar, rising oil prices and a “decoupled” world economy made America’s central bank more hawkish. Although it did not raise rates, “inflation jitters” were pervasive. The European Central Bank actually raised rates in July 2008.

History will not repeat itself exactly. But bubbly asset prices do risk overreaction from rich-world central bankers. That may temper worries in the emerging world but at the risk of pushing the global economy back into recession. Central bankers ignore asset prices at their peril. But dealing with them is not easy either.