Two decades ago, I created a broad price index to correct the conventional price measures statistical deficiencies and incorporate asset prices into the overall discussion of inflation. In the past 25 years, there were two periods (the late 1990s and early 2000s and 2004 to 2007) in which the broad price index showed significant and persistent increases indicating that monetary policy was far too easy and for too long. The unwinding of those price cycles triggered partly by official rate hikes ended in recession, one far worse than the other.
The increase in the broad price index in 2021 is more than twice the dot-com boom and housing bubble. The monster price cycle requires forceful action by policymakers. Every business cycle in the past 50 years except one ended with the fed funds standing above the rate of consumer price inflation. Two to three hundred basis points increase in the fed funds rate over the next two years looks aggressive, but it's not when the policy rate is at zero and inflation at 6%+.
Since easy money is fuel to all parts of the price cycle, policymakers cannot aim for one part without impacting every aspect. Based on the past two episodes, it is inevitable that the unwinding of the record price cycle will trigger adverse economic and financial adjustments. Record debt levels at the consumer and business levels increase the odds of an awful outcome.
Broad Price Index
I created a broad price index for two reasons. First, politics and statistical issues removed real estate prices from conventional measures and replaced them with non-market prices. Second, in the famous "irrational exuberance" speech, former Fed Chair Alan Greenspan asked, "Where do we draw the line on what prices matter?"
Mr. Greenspan never answered the question. But he soon discovered under his watch with the dot.com bubble that there was nothing unique about asset markets to imply that rapid increases in prices fueled by easy money and credit can extend indefinitely without creating costly imbalances.
Historically, policymakers viewed asset price inflation as a signal of more robust growth and the potential for more general inflation down the road. Yet, the past decades have schooled policymakers that rapid asset inflation could occur without significant inflation in conventional price measures. And, the unwind of those price cycles can destabilize the broad economy as bad if not worse than a traditional inflation cycle.
The broad price index includes consumer prices, producer prices, and real estate and financial asset prices. The design of the weighting scheme approximated the relative importance of each sector to the economy and finance. Consumer prices had the dominant weight, consistent with the consumer share in the economy; producer prices at all three stages of processing (excluding food and energy at the lower two stages to avoid double counting) had a weight equal to the business investment share of GDP. Existing and new house prices had the next larger share, and stock prices had the smallest share.
Critics will argue that stock and real estate prices should not be a monetary policy target. Policymakers should not target any specific price. But incorporating asset prices in a broad index enables them to move beyond an analytical price framework that has become too narrow. Also, a comprehensive price index helps distinguish between relative and absolute price movements. And, significant and persistent increases in a broad price index is a warning sign just as similar significant increases in conventional price measures that the stance of monetary policy is too easy.
I recently updated the broad price index for 2021. The increase in the broad price index is far beyond anything that I ever thought possible. Based on data through October, the increase in the past twelve months is 11%+. The broad price index peaked at 5%+ during the dot.com era and 6%+ during the housing bubble.
In other words, the current broad price cycle is more excessive than the dot.com and house price cycles by a factor of two. And others agree with the excessiveness. Charles Munger, the vice-chairman of Berkshire Hathaway, said last week, "The dot-com boom was crazier on the valuations even than we have now, but overall, I consider this era even crazier than the dot-com era,"
Mr. Munger spoke about the excessiveness in the equity market. But excessive price moves are seen everywhere. Consumer prices are up 6.2%, producer prices for finished goods have increased 12.5%, intermediate materials and crude goods prices, excluding food and energy, have increased 22.6% and 30.6%, respectively. And house prices, according to Case-Shiller, are up close to 20%.
Policymakers misread the full scope of the inflation cycle and need to play catch-up. In every business cycle of the past 50 years, the peak in the fed funds exceeded consumer price inflation. The exception was the last cycle, which ended in February 2020 when the pandemic hit. Starting at zero, the Fed has a long way to go to lift official rates to a reasonable level. Two to three hundred basis points over the next two years sound like a lot, but in reality, it's not with inflation far above the Fed's target, and the full employment mandate achieved as well.
Investors have focused on the positives of inflation cycles and overlooked the negative aspects. Inflation cycles positively influence liquidity, revenues, incomes, and profits on the way up and have a significant adverse effect on the same items as they come crashing down. The more severe economic and financial dislocations from inflation cycles are those where there is a massive overhang of debt. Consumers have record levels of margin debt, credit cards, and mortgage debt, and business debt levels are at record levels.
Investors should know how the inflation cycle script ends as it has been a recurring outcome in all business cycles. Recession and sharp declines in asset prices are the standard scripts.