The Central (Banking) Importance of Asset Inflation
By Charles Zentay
July 27, 2007
Over the last several years, central bankers around the world have debated whether they should be fighting asset inflation as well as price inflation. As asset prices have gone up, the intensity of the debate has increased. The consensus thinking among U.S. central bankers, led by former Fed Chairman Alan Greenspan and current Fed Chairman Ben Bernanke, is that the Fed should focus only on its dual directives of containing price inflation and sustaining economic growth; the market should be in charge of controlling asset inflation. However, many central bankers in Europe and other countries have taken a different stance, arguing that they should proactively fight asset inflation.
In the United States and in many other parts of the world, the last decade has witnessed significant asset inflation, especially in real estate and private equity valuations. All the while, price inflation has been moderate and economic growth has been strong. This scenario has been called the “Goldilocks economy,” not too hot and not too cold. Just right. However, the dissenting central banks have argued that this benign environment is masking a high degree of risks. Some of those risks have, in fact, come to the forefront recently, with worldwide markets falling due to housing weakness and busted private equity deals.
Sometimes, I believe, economists and analysts get lost in the complexity and forget the simplicity. For example, the top ratings analysts at S&P’s and Moody’s have developed complex forecasting models to rate hundreds of billions of dollars in CDOs, which are a derivative of mortgage loans. These ratings agencies have used decades of historical data to guide their complex models. All very impressive stuff, until you realize that the lending that has been occurring over the last 5 years is non-historical in nature. Now these brainy analysts are scratching their heads and expressing shock that their models are turning out so wrong. They never asked the simple and practical question: are loans that drive the data for our models being made in the same way as our historical data?
Along the same lines, I believe U.S. central bankers are not asking themselves a very simple question with regard to asset inflation, namely: what do higher asset prices mean for businesses? Let me give you an example. Let’s look at the real estate business. Since 1991, real estate prices have moved upwards until about a year or two ago. The rise during the last few years of boom was especially accelerated. Today, many home shoppers complain about how un-affordable housing is relative to their incomes.
To understand the problem with real estate price inflation, we must understand Cap Rates. A Cap Rate is the net rent of a property divided by the price of the property. For example, if your property generates $10,000 a year, and your administrative costs are $2,000 a year, you have net rent of $8,000 a year. Let’s say your property is worth $200,000. $8,000 divided by $200,000 is 4%. You have a Cap Rate of 4%. Many properties in the U.S. currently have Cap Rates between 3% and 5%, very low rates of return by historical standards. That is because asset inflation has been so dramatic. Assets increased in value significantly but rents did not. Historically, Cap Rates have been a couple percentages above mortgage rates – as you would expect. Landlords wanted compensation for the hassle of doing their jobs. Today, however, Cap Rates are BELOW mortgage rates, meaning if you want to be a landlord, you have to PAY to do your job. Now, I would certainly pay to be in the starting line-up of the Boston Redsox, or I’d pay to be Lindsay Lohan’s designated driver. That’s fun stuff. But being a landlord?
Why all this talk about jobs you have to pay to do? Well, let’s return to our central question: what do higher asset prices mean for businesses? In today’s real estate market, it simply does not make sense to expand. The more projects you do, the more money you lose. The Cap Rates do not cover the mortgage costs, unless one of two things happens: either (a) house prices drop; or (b) rents go up.1 So, either the price of the asset goes down, and therefore Cap Rates go up; or the income from the asset goes up, and therefore Cap Rates go up.
If you take this scenario for real estate and apply it to asset inflation across the entire economy, you have the following conclusion: once asset prices get too high, either the market has to contract, or price inflation has to occur. Simply put, the problem with asset inflation is that it puts the Fed’s two directives (moderate price inflation and sustainable economic growth) on a collision course.
Today, the market is trying to correct the asset inflation that has occurred. As expected, we are experiencing mild asset deflation (and slow economic growth) and mild price inflation. So far this asset deflation and price inflation has been slow, but storm clouds are brewing. Economic growth is threatened by the “no-end-in-sight” subprime contraction, falling housing prices, busted private equity deals, banking credit concerns, and more. Simultaneously, inflation is more of a concern, due to higher utilization rates, full employment, hints at higher wages, a falling dollar, significant commodity inflation, etc. It has been interested to see the market fall so much this week, yet oil prices increase!
So if you were to ask me: should the Fed add asset inflation to its list of directives? I would ask: what do higher asset prices mean for businesses? And if you came to the same conclusion as me, then I’d say that Alan Greenspan and Ben Bernanke have taken us down the wrong path.
1 For those readers savvy in the ways of finance, you’re probably wishing you could raise your hand and say, “But there is a third option: mortgage rates could go down.” Indeed, they could, but in a time of $75 oil, rapidly accelerating food prices, full employment, and a falling dollar, where the Fed’s stated main concern is inflation, such a move would seem unwise. In addition, there is a limit at which lower interest rates will alleviate the problems brought on by asset inflation. That limit is 0%. Rates cannot go lower.
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