The Other Inflation. and Why Boom/Bust Cycles May Be Here To Stay

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1 and Why Boom/Bust Cycles May Be Here To Stay At the heart of every central bank mandate around the world is some type of inflation target. This can be explicit (e.g., the Fed s 2% target) or implicit (e.g., price stability ), but inflation is typically the most important piece of feedback that an economy gives to its central bankers with regards to current monetary policy. If inflation is too low, more stimulus is needed lest the economy fall into a deflationary spiral of falling prices and falling demand like the one that has gripped Japan for the better part of the past 25 years. If inflation is running above target, that is the clearest signal to central bankers that they should begin to tighten liquidity before the economy overheats. It all seems simple enough. Unfortunately, in our opinion, central banks have been too narrowly focused on just one type of inflation. In their attempts to revive lackluster consumer price inflation with ever more monetary stimulus, central banks have instead fostered excessive asset price inflation. At extremes, asset price inflation can be even more dangerous than the consumer variety, as asset bubbles inevitably correct themselves in very painful and destructive ways when it is least expected (e.g., the Global Financial Crisis). Ironically, for central banks so terrified of potential deflation, allowing an asset bubble to inflate and then collapse is one of the most deflationary things they could do. Until the potential dangers of asset price inflation are recognized and addressed, global financial markets may be trapped in a higher amplitude cycle of boom and bust. MEKETA FIDUCIARY MANAGEMENT, LLC DECEMBER 2017

2 Consumer Prices Consumer prices 1 in the United States have been remarkably stable since the high inflation era of the 1970 s and early 1980 s. Over the past thirty years central bankers have been quick to take credit for taming inflation through their micromanagement of monetary policy. In reality, there have been a number of structural economic trends that have held down consumer prices over this time period, most of which have nothing to do with the Fed or its policies. The first is globalization. When China officially entered the World Trade Organization in 2001, it introduced hundreds of millions of new low-cost participants into the global workforce. Other emerging economies have followed suit. Combined with huge advancements in outsourcing and logistics, global manufacturers can now produce everything from televisions to tennis shoes at a fraction of the prior cost; allowing them to lower prices while still raising profits. In recent years, the disinflationary trend towards globalization has been exacerbated by the trend towards automation. Companies today are not only replacing high cost human labor with low cost human labor, but are now increasingly replacing low cost human labor with robots. This shift has further lowered the cost of producing consumer goods and moderated any potential price increases. 1 While consumer price increases are typically quoted in the press using the Consumer Price Index (CPI), the Federal Reserve actually uses a slightly different metric called Personal Consumption Expenditures (PCE). The two metrics are roughly the same, with some slight differences in factor weightings and measurement techniques. Furthermore, the Fed focuses on Core PCE, which strips out the more volatile food and energy components to give a more stable picture of underlying trend inflation. 2

3 Growth of $100 Source: Fred This has created an environment where the Fed waits for higher consumer price inflation to tell them when to tighten monetary policy (and by how much), but that feedback loop has been broken (or at least muted) by these structural headwinds. The end result over the past twenty years or so is that the Fed has been perpetually behind the curve (i.e., they leave monetary policy too loose for too long). This wouldn t be such a bad thing were it not for one of the dangerous side effects of excessively loose monetary policy financial speculation. Asset Prices Over the past 17 years, by focusing on consumer price inflation rather than asset price inflation, the Fed has missed two of the largest financial bubbles in history (and is arguably in the process of missing a third). The first is the Tech Bubble of the late 1990 s. While consumer price inflation (Core PCE) averaged just 1.7% per year from 1995 to 1999, the Nasdaq jumped over 500% in the same time period before ultimately falling over 80% from its peak. Nasdaq Core PCE $650 $550 Asset Inflation (43%/year) $450 $350 $250 $150 Consumer Inflation (1.6%/year) $50 3

4 Growth of $100 In the aftermath of the Tech Bubble, the Fed drastically cut interest rates to help the economy recover from a brief recession in After the economy fully recovered, the Fed began to gradually raise interest rates again in a very measured and carefully telegraphed fashion from June 2004 to August On the surface, this appeared to be the right approach as consumer price inflation held relatively steady around 2.1% per year. The housing market, however, was a different story. The Case-Shiller Home Price Index was increasing over 10% per year in the early-to-mid 2000 s (and was up significantly more in certain areas of the country). Home prices were becoming completely disconnected from the household incomes meant to support them, but again, the Fed and their myopic focus on consumer price inflation failed to see another asset bubble in the making. Case-Shiller Index Core PCE $150 $140 Asset Inflation (11%/year) $130 $120 $110 Consumer Inflation (2%/year) $100 $90 In response to the Global Financial Crisis that followed, the Fed cut interest rates to zero, and when that wasn t enough, they looked to other forms of monetary stimulus such as Quantitative Easing. While the Fed has begun to slowly tighten monetary conditions again, we are still at levels today that would qualify as emergency stimulus in any other era and would be viewed as highly inappropriate for an economy that is now nine years into a recovery. Unfortunately, the same movie seems to be playing out again. Consumer price inflation has been consistently below the Fed s 2% target (something Janet Yellen has referred to as a mystery ), but there has been no shortage of asset price inflation. Over the past nine years the price of essentially every asset has soared to record (or near-record) highs; from stocks and bonds to commercial real estate to art and classic cars. Time will tell if the Fed is able to engineer a different outcome this time around, but the historical parallels are not encouraging. 4

5 Growth of $100 S&P 500 Core PCE $230 $210 $190 $170 Asset Inflation (11%/year) $150 $130 $110 Consumer Inflation (1.5%/year) $90 Conclusion The past twenty years have given us some of the biggest boom/bust financial market cycles in US history. While each cycle has had some unique characteristics, the one common underlying theme has been excessively loose monetary policy from the Fed. Everyone loves asset bubbles on the way up, but the more asset prices are allowed to disconnect from underlying fundamentals, the more painful the inevitable pay back. While certainly not the only factor, in our opinion, the Fed s focus on consumer price inflation at the expense of asset price inflation has greatly contributed to this dynamic. Until this critical flaw in the Fed s (and other central banks ) reaction function is addressed, investors should expect a continuation of boom/bust financial markets. 5

6 About Meketa is a subsidiary of Meketa Investment Group focused exclusively on discretionary Investment Services. We offer a fully customizable discretionary solution, specifically tailored to each client s needs and circumstances. This organizational structure provides clients with the attention and client service of a boutique OCIO firm, as well as the depth of resources of a global consulting business. Meketa Investment Group was founded in 1974 as an investment partnership. In 1978, the firm was incorporated under Massachusetts law and became registered with the Securities and Exchange Commission as an investment adviser. We have been in business continuously for over 39 years. Meketa Investment Group was hired by its first client in 1978, a relationship that continues to this day. The firm has grown steadily, and consults on over $600 billion in assets, $7 billion on a discretionary basis, for over 165 clients. For more information, please us at info@meketafm.com. All opinions, news, research, analyses, prices, or other information is provided as general market commentary and not as investment advice. No representation is being made that results and past performance discussed within this document is indicative of future performance Armada Drive, Suite 110 Carlsbad, CA