I just posted on this as a follow up comment to The Big Takeaway, but it merits a post of its own:
According to a report on Bloomberg, Bill Dudley said today that in order to get consumer price inflation down, asset prices have to deflate. This would be the first tacit recognition I’ve heard by anyone else of a point I’ve been making for years on iTulip and Financology – that asset price inflation and consumer price inflation are closely related.
If Stocks Don’t Fall, the Fed Needs to Force Them
This is big news, folks … Dudley is a former president of the New York Fed and I think this will ultimately factor into the Fed’s policymaking … that if asset price deflation doesn’t occur as an organic consequence of tighter monetary policy, the Fed will actively seek to force asset prices down.
13 thoughts on “The Fed May Actively Seek To Deflate Asset Prices”
It should be apparent that this calls into greater question Synthetic System’s call for a summer rally in stocks. While it’s possible that Dudley’s view doesn’t quickly find consensus in the FOMC, if asset prices do indeed resume inflating bigly, consumer price inflation will not relent and the Fed will tighten even more aggressively. While SS currently doesn’t see stocks deflating before fall, the risk falls disproportionately on the sooner rather than later side.
problem: federal tax receipts are greatly dependent on stock prices. any prolonged drop in equities will increase the deficit and require more paper issuance at the same time the fed is doing qt. rates may climb faster and higher than intended, then promoting an overreaction the other way. Dudley and the fed have to be careful what they wish for.
this scenario is consistent with your ss projection of a deep drop in bond prices
There’s more than one way to skin a cat … the federal government has been living large as inflation has gone mostly into asset prices over the past decade. Yes it can issue more paper, but it can also increase taxes and limit spending. My guess is we’ll probably get some of all three.
All that is spent has to come from somewhere. At one extreme, the government could not levy any direct taxes at all and just print to fund its expenditures. At the other, it could fund it all with direct taxes. Direct taxes are ultimately the honest way of funding spending because voters see the costs of politicians’ programs directly and can make rational cost benefit choices. Funding federal spending through inflation hides these costs and frustrates the cost benefit analysis process. Instead voters pay the costs of government programs in their groceries, rent, utilities, insurance, at the gas pump, etcetera. That way the costs of federal programs get blamed on greedy corporations, bad weather, viruses, foreign bad guys …
Thank you, Bill. I much appreciate your thoughts.
Do you think this will have any impact on hard assets like copper, for example?
Absolutely. The question is really just when. SS thinks later this year, but we can’t rule out the possibility it happens sooner, as JK notes and I discuss in my reply. On balance the odds favor commodity prices continuing upwards for a while before reversing sharply to the downside, but the risk is clearly increasing.
This sounds like the reversal of “Wealth Effect” that the Fed used to justify its support for asset prices, including shares. I think an unintended consequence of this action is driving share buybacks by corporates into the headwinds of constantly increasing asset prices to manage their EPS numbers and compensate for the issue of managements’ share options.
It will be interesting to see how corporations behave in a scenario of asset price deflation.
A question. Does “asset price inflation and consumer price inflation are closely related” mean one drives the other or they both are different aspects of an overall inflationary phase of the economy that appear with a lag, asset prices first followed by consumer prices?
Dudley’s comments indicate he’s looking at it from the standpoint of tightening “financial conditions”. A fuzzy construct at best. You could say that “wealth effect” is another way of looking at the same thing.
My way of looking at it is that all prices are affected by changes in the value of the pricing unit. But that not all prices respond at the same time. Generally bond prices move first since that’s where Fed policy acts (interest rates and bond yields move inversely to prices). Stocks, also priced in real time, follow closely. As the price effects of changes in the value of currency work their way through the system, consumer prices and wages are eventually affected.
Consumer prices incorporate elements with variable lags. Commodity inputs change quickly, while wage components can take years. Wages are often set by multi-year contracts, so that the slack is mostly taken up by changes in the balance between labor supply and demand, that is, unemployment rates. To the extent consumer prices incorporate wage costs, they too can take years to respond. Take for example the last decade … inflation was almost all manifested in asset prices … this decade it’s finally spilling over into consumer prices. Ultimately they must converge, since the aggregate purchasing power stored in assets cannot exceed the body of consumer goods and services available for purchase.
This is discussed in more depth in The Big Takeaway.
Thank you for the reply, much appreciated,
what do you think about commodities, esp energy, ag and fertilizer companies, uranium? i can make an argument that they should hold up better than stocks, and even rise as stocks fall, but otoh i can make an argument the other way.
It’s messy. My best guess is that the SS outlook has the edge … that commodity prices will continue higher for a while. There’s historical precedent for that too … stock prices topped out in October 2007 while commodity prices continued higher into the middle of 2008. Of course neither SS nor historical precedent is infallible and as you say it’s possible to imagine fundamental circumstances that could pressure commodity prices sooner. I can only say I tend to agree that the odds favor the first scenario. In the longer run at least commodities are still cheap compared to US stocks and have an outperformance tailwind.