Asset Price Inflation: Contributors and Consequences

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The article below is reprinted with permission from The Capital Issue, a quarterly newsletter published by Lancaster Pollard.

Conventional wisdom has that looking back to the past often is the best way to prepare for the future. If that’s the case, let's take a look back at recent history in regards to the Federal Reserve Board in regards to asset prices.

The U.S. equity markets were recovering from the bursting of the tech bubble in 2000 as the economy slipped into recession in 2001. The desire of the Fed at that time was to reduce market interest rates in order to stimulate economic activity largely through increasing expenditures on capital goods by reducing financing costs.

After touching a low of 3.13 percent in June 2003 (as noted by the dashed vertical line in Figure 1), the yield on the 10-year Treasury note began to move upward, even as the Fed had pushed the target federal funds rate to 1 percent. Rising 150 basis points to over 4.6 percent in less than three months, the 10-year Treasury note continued to move higher, reaching a cyclical peak of 5.25 percent in June 2006.

US interest rates



Throughout this period, the Fed also sought to improve bank balance sheets by reducing short-term interest rates as a way to reduce a bank's cost of funds. Coupled with stable and somewhat higher long-term (i.e., lending) rates, bank net interest margins began to improve. Net interest margin is the difference between the lending rate and the banks' cost of funds. A higher NIM generally results in improved profitability and stronger balance sheet. A stronger balance sheet, in turn, increases the banks' capacity to lend, injecting liquidity into the capital markets. However, an increased capacity to lend does not automatically result in an increase in loan volume. This was especially true for the period after the credit market freeze of 2008.

According to the Federal Reserve Bank of St. Louis in October 2012, between the fourth quarter of 2008, when the Federal Open Market Committee reduced its federal funds target rate to virtually zero, and the first quarter of 2010, the net interest margin increased by 21 percent, its highest level in more than seven years. The bank's report concluded that the amount of commercial and industrial loans on bank balance sheets declined by nearly 25 percent from its peak in October 2008 to June 2010.

The dearth of lending was an extreme reaction to an overheated real estate market, driven in part by easy money of the previous period. Although there were few professionals who could foresee the extent of the credit market freeze, some market observers believed that the low interest rates of 2003 and 2004 may have contributed to excessively high asset prices.

In April 2006, after a sustained period of low interest rates, former Federal Reserve Chairman Alan Greenspan warned of an overabundance of liquidity that would result in an asset price decline. Speaking to the Asian Financial Centers Summit in Seoul, Korea, Chairman Greenspan noted that the market value of assets had been rising faster than gross domestic product growth, as a result of a "decline in real equity premiums" and the decline in real long-term interest rates. He went on to say "that cannot go on indefinitely."

Asset prices and interest rate sensitivity

Although housing investments tend to be more interest rate sensitive, equity investments also tend to react to a low interest rate environment. Greenspan considered the value of this very liquid and widely dispersed asset to be at risk as well. The Dow Jones industrial average was at 11,000 at the time as the United States was nearing the end of the housing boom.

The increase in short-term interest rates shown in 2005 and 2006 (Figure 1) was intended to stave off unwarranted asset price increases while addressing the possibility of an increase in inflation. The short-term rate increases did nothing to mitigate the upward momentum of the stock market as the Dow continued its ascent until October 2007, when it exceeded 14,000. Nor did the market perceive a significant inflationary threat.

A year later the Dow had fallen below 8,400, on its way to an inter-day low of 6,469 in March 2009. In less than 18 months, the euphoria of ever-increasing stock prices had turned into panic. Just as equity investors saw in the 1987 crash, pundits compared the stock market decline to that which precipitated the Great Depression.

Concurrent with the stock market decline and to encourage the availability of credit, the Fed responded by quickly reducing short-term interest rates from 5.25 percent in October 2007 to nearly zero in December 2008.

Back to the future?

Well into the recovery period after the Great Recession, the Fed has maintained a low interest rate posture and has even provided market participants specific triggers before deciding to modify its existing interest rate guidance, such as inflation and unemployment targets. In existence for over four years, the cycle of low short-term interest rates continues today as the Fed Funds target rate remains near zero. Over the same period, the 10-year treasury yield has fallen from 5.25 percent to about 2 percent today.

The current low interest rate environment has affirmed its contribution to an increase in asset prices, as the Dow has again traded above 14,000 (Figure 2) and housing markets are showing signs of recovery.

Dow Jones Industrial Average



The Fed response

The Federal Reserve Bank has access to financial tools not available to any other market participant. In addition to open market activities, including repurchase agreements and the issuance of treasury bills, notes and bonds, the Fed has expanded powers to include the purchase and sale of federal agency debt and mortgage-backed securities. Use of these tools has contributed to a significant reduction in both short-term and long-term interest rates.

In spite of these tools and the advantage of employing some of the greatest economic minds of our time, recent history has shown that the Federal Reserve Board cannot sufficiently anticipate and seemingly cannot prevent a substantial decline in asset prices, most notably equity and real estate markets, even when the Fed ostensibly caused the asset price increase through a sustained low interest rate environment. The response from the Fed is reactive at best.

Logically, investors should not rely on the Fed for guidance through its open market activities as a leading indicator of future asset values. Nor should investors become distracted by the euphoria of ever increasing asset prices. Rather, disciplined investors should review their unique risk profile and adjust asset allocations accordingly, being mindful of new market risks while being a student of history.

William M. Courson is the president of Lancaster Pollard Investment Advisory Group in Columbus. He may be reached at wcourson@lancasterpollard.com.

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