The Hindu Business Line : Asset price inflation trumps consumer price index

At its meeting last week, the Federal Open Market Committee (FOMC), which is charged with the conduct of the US monetary policy, expectedly left interest rates where they were.

It did not stop with that but virtually promised a prolonged period of near zero rates.

The economy continues to bleed. GDP fell 5.5 per cent annualised in the latest quarterly figures. The most optimistic forecasts do not see the figure turning positive till practically the last quarter of this year.

This crisis is different

The current crisis is clearly different. For one, it is not part of the usual down of up-down business and economic cycles, which can be treated with the traditional medicine of lowering interest rates. In other instances, setbacks stemmed from a collapse of the stock market. The most recent example is that of the Internet-driven boom of the 1990s, whose end brought the Nasdaq to a fifth of its peak. In emerging economies, balance of payments problems followed by currency crashes were a common cause of the downfall of markets and economies.

Even housing bubbles — the proximate reason for the present problems — have been seen — and seen off — by governments and central banks before. The distinctive feature of the prevailing situation is that the housing-related asset portfolios of financial institutions are contaminated on a never-before-seen scale, because the motive, on their part, in the first place, was not to finance houses but financial engineering. What is more, in the case of banks, the funding was highly leveraged and short term. When house prices fell they were hit twice: in their own trading and investment positions, on the one hand, and in financing those of their subsidiaries, special purpose vehicles and big customers, like hedge funds, on the other.

Willy nilly, the real economy is more financial market driven than at any time before in history — to the point that many corporates thought there was easy money to be made in exotic financial products. (Witness the recent destruction of one of India’s high-profile pharmaceutical companies which ventured into hundreds of millions of dollars of complex derivatives.)

Monetary policy seems to have reached its limits in the rich economies. No wonder, Mr Warren Buffett, the billionaire investor, thinks a second stimulus package necessary.

Beyond these, what are we looking for? Undoubtedly, stability and improving house prices. That would remove a lot of pressure off the collateral in banks’ balance-sheets.

Otherwise, the Obama-injected capital and funds into banks will not go into lending to business but financial market circulation with no net benefit to the economy but only profits and bonuses at banks.

API — Asset Price Inflation — not the Consumer Price Index holds the keys.

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