Beware: we could soon face new bubble
UNTIL recently, the worry about quantitative easing was that it was not working well enough, a view which has long stuck me as excessively pessimistic. But in recent days several top economists have started to express fears the policy may actually have worked too well and that all of the liquidity being injected into the system could be fuelling a new bubble.
We are not there yet; but I certainly agree that it is a growing danger. Some asset prices have recovered too quickly; interest rates on gilts are too low as a result of the false market created by the Bank of England’s massive purchases; several other key prices seem out of sink. The return of the carry trade – investors borrowing in a currency with low interest rates, such as the greenback, and investing in one with higher interest rates, such as Australia – are also fuelling liquidity. Foreign exchange reserves have dipped but remain at elevated levels; they are likely to start going up again, contrary to what the G20 is hoping for. If much of the rebound in asset prices has been liquidity-driven, the eventual removal of this crutch may send prices tumbling 10-15 per cent.
Spencer Dale, the Bank of England’s chief economist, warned yesterday that central banks had limited experience of using quantitative easing and therefore did not fully understand all of its consequences. He conceded that “the substantial injections of liquidity might result in unwarranted increases in some asset prices that could prove costly to rectify”. Barclays Capital’s quarterly economic report also flagged up that risk.
Yet the “all is fine” brigade point to the money supply, which is still growing slowly. They have a partial point. But even though the amount of money circulating across the G7 has gone up by only 2 per cent at an annualised rate in the six months to August, the speed at which this money is being passed around consumers, businesses and investors has started to accelerate again. This process – economists call it an increase in velocity – has a similar effect as a rise in the volume of money and suggests liquidity is recovering faster than many realise. One gauge of this – calculated by Simon Ward of Henderson New Star – suggests that velocity may be increasing at the fastest rate since 1992-3, when it jumped by 4-5 per cent per annum.
Not all of the evidence marshaled by the pro-bubble camp is correct. Much of the stock market recovery is warranted. The argument that corporate profit increases are only due to cost-cutting (rather than growth in demand) and are therefore not sustainable is flawed. Higher profits often drive investment and growth; cost reductions are often permanent and sometimes help cause a recovery in demand. I have argued in this space previously that house prices in the UK were reasonably fairly valued at the moment on the basis of a range of metrics, including price to earnings ratios and rental yields compared to mortgage rates. I stand by this assessment (even though it generated a very large volume of disapproving comments) though of course if prices continue to rebound (rather than stagnate) I will soon begin to worry again about their sustainability.
For all of these caveats, we could soon be entering another, extremely dangerous bubble in several asset classes. I will be monitoring all of the data closely; watch this space.
[email protected]