Fed should include asset price trends in policy adjustments

The Federal Reserve has repeatedly pointed to subdued inflation as a justification for carrying on with its efforts to stimulate the economy in the United States. It should be paying much more attention to a trend that its inflationary gauge is missing: the tremendous run-up in the prices of all kinds of assets.

One need look no further than the stock market to see that something is awry. In 2013, US equity prices rose 28.3 per cent in inflation-adjusted terms, while the comparable pace of growth in the broader economy was only 2.2 per cent.

In other words, in real terms, equity prices grew almost 13 times faster than the economic activity required to justify them - the highest ratio since the abandonment of the gold standard in 1971. In 2014, the ratio is on track to exceed five for a third year.

Such large disparities often end badly. In developed-nation peers, the ratio of real equity appreciation to real gross domestic product growth has topped five for at least three consecutive years on seven occasions since 1971 - once in Australia, twice in France, twice in Germany, once in Switzerland and once in Britain. None of the streaks lasted more than four years, and the hangovers were ugly: in the following year, equity prices declined by an average of 16.4 per cent in inflation-adjusted terms.

By looking only at consumer prices and wages, the Fed's inflation barometers focus on a part of the picture that is no longer representative. Globalisation has put a ceiling on the prices of many goods and services. Technological advancements such as robotics have provided a similar check on wage growth by lowering the demand for human labour.

As a result, the relationship between monetary policy and traditional inflation indicators has frayed. In a world where financial innovation has given almost everybody access to credit, easy money flows right past goods and services into asset markets, where it pushes up the prices of stocks, bonds and real estate.

Some of the most devastating financial downturns in recent history were engendered by asset inflation. Even as credit expanded 11 per cent per year in the late 1980s and asset prices surged, consumer prices rose just 1 per cent annually and offered no clue of the impending disaster. More recently, an asset price collapse in the US triggered the 2008 financial crisis. Again, despite massive credit growth and asset inflation, growth in US consumer prices was subdued.