I was reading Scott Sumner’s explanation of the hot potato effect, intrigued by how Fed policy is affecting asset prices. This is the $64,000 question: are low interest rates keeping asset prices artificially high, portending another bubble bursting? I’ve read a lot on this score, mainly from folks terrified by high PE/CAPE ratios. I personally believe the stock market is fairly valued. I also don’t believe we’re back in a housing bubble, despite rising prices.
First of all, what is the “hot potato effect”? Imagine a mining company found a gold cache of unimaginable proportions and began digging it up. The company wouldn’t simply hold the gold, they would sell it as quickly as possible to others, who would then resell it. But the price of gold would tumble immediately on the expectation that all that gold would be mined and sold and re-sold and re-sold. Gold is passed along like a hot potato.
But if gold is the currency, the price of gold is fixed. Therefore prices for goods and services would adjust upwards based on the new discovery. However, because of human behavior, prices are sticky, so the rise would be gradual rather than immediate. In the case of cash, if the Fed doubles the amount of money in circulation, you’d expect prices to double. But you can’t demand a 100% raise from your boss the day after the Fed printed that amount of money. Over time, however, you would (depending on supply and demand for your particular labor).
The hot potato effect reminds me of the town of Deadwood. With big gold discoveries in the Black Hills, prospectors flocked west to dig up and spend the buried gold. Prices everywhere didn’t jump immediately. But near Deadwood they did. With more gold than goods, prices would have been much higher in Deadwood than any point east. As the gold made its way east, and the goods west, the price differential would have faded. Eventually prices everywhere would have risen (gold was the medium of exchange) based on the increased supply of gold relative to goods.
How does this relate to the Federal Reserve now? Think of QE as a massive discovery of gold. But instead of requiring millions in capital and labor to dig up, the Fed can just make an electronic transfer of this new cash to banks, who will then lend it out. Again, like an earthquake, the price change required from the massive new amount of currency will ripple outwards from the source of the money to the periphery.
Gold was physically mined, so it’s geographically possible to pinpoint the source of gold and the furthest point it would have to travel. Extra cash on the Fed balance sheet is harder. Suffice to say, we would see the affects of a larger Fed balance sheet in more liquid markets first, less liquid markets later. Wages are stickier than house prices. House prices stickier than equities prices. Equities stickier than bonds. So bonds are where we see the first affects of QE. Prices rise, yields fall. Then stock prices rise. Then physical assets ruled by financial securities like houses rise. Then wages and prices in the real economy rise.
In that sense, stocks, bonds and houses aren’t overvalued. They are just leading the overall reflation of the American economy. There is a flaw (and therefore a risk) in this logic. We wouldn’t expect Deadwood’s gold to be re-buried. But most experts do expect the Fed to exit QE. It’s just too unconventional and dangerous, they say, to keep all that extra money in circulation.
If the Fed promised tomorrow to never exit QE, we would have inflation at the desired amount (maybe quite a bit more). Interest rates would shoot up to a level commensurate with “normal” monetary conditions (they could in fact be higher if inflation was higher than expected).
But with the expectation that the Fed will undo QE (in essence re-burying the gold), where does that leave stocks, houses and wages? Well, we’re all forced to adjust our expectations to what the Fed has made clear.
- The Fed will not tolerate a collapse in demand like 2008
- The Fed seems unwilling to tolerate deflation (or much lower than 1% inflation)
- The Fed seems unwilling to contemplate greater than 2% inflation
Based on that ‘policy’, what does that mean for investors, homeowners and workers? It means economic growth will likely remain positive, but not booming. It means inflation will hover between 1%-2%. And it means interest rates will be around 2% for a long while as the economy grows just fast enough for the Fed to avoid more rounds of QE, but not quite fast enough to generate more than 2% inflation.
With bonds yielding 2%, housing prices will continue to adjust upwards based on lower mortgage payments per rent. And equities seem fairly valued, albeit with a lower expectation of future nominal returns. If the Fed gets more serious about reflation, there could be a market boom. But if the Fed lets conditions tighten without action, there would be a bust, followed by a quick turnaround.