The cure for asset bubbles: Inflation

Michael Mackenzie

A central banker has many tools at his or her disposal, including that of the bully pulpit.

Words count and usually move markets, at least in the short term. This week the Nasdaq biotechnology index, which trades at about 500 times its earnings, has slipped nearly 6 per cent in the wake of being identified by the Federal Reserve as having "stretched" valuations.

Federal Reserve Board Chair Janet Yellen testifies before the Senate Banking, Housing and Urban Affairs Committee July 15, 2014 in Washington.
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But for all the concern expressed by Fed chairwoman Janet Yellen and the central bank this week that certain asset classes were rather rich, we are unlikely to see pre-emptive action in the form of tighter rates to nip excessive or bubbly prices, until the economy is much stronger and inflation is firmly established.

Relying on jawboning markets is nothing new. In December 1996, Alan Greenspan famously pondered "how do we know when irrational exuberance has unduly escalated asset values?"

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The answer to Greenspan's rumination did not arrive for more than another three years, as the internet bubble was only getting going in late 1996.

What troubles many at this juncture is how an extended cycle of low interest rate policy, that began in late 2008, in conjunction with massive purchases of bonds by the Fed, has ignited asset values.

From record equity prices to meagre risk premiums on all types of bonds, investors have pumped money into a multitude of financial assets and property thanks to the central bank's strenuous stimulus efforts.

Michael Kastner, principal at Halyard Asset Management, says the common refrain from retail and professional investors is the complaint that they need to do something with their cash.

Read MoreFed says valuations stretched for smaller social social media & biotech stocks

The amount of cash sitting on the sidelines, known as money market fund balances, stands at about $2.575tn, where it stood in 2007 before the financial crisis erupted.

In March 2009, money markets were holding nearly $4tn as investors were firmly in bunker mode. Since then that cash kitty, earning essentially nothing, has normalised, driven by the search for yield. That is an activity that flashes red on the radar screen of central bankers.

Ms Yellen this week told Congress that valuations for lower-rated corporate debt "appear stretched" and added "low interest rates may provide incentives for some investors to 'reach for yield' and those actions could increase vulnerabilities in the financial system to adverse events".

Read MoreDruckenmiller: Fed policy 'fraught with unappreciated risk'

The Fed's accompanying Monetary Policy Report provided more details: "Equity valuations of smaller firms as well as social media and biotechnology firms appear to be stretched, with ratios of prices to forward earnings remaining high relative to historical norms."

Beyond valuations, there is also the issue of how investor behaviour in terms of risk taking has been altered by an extended period of low interest rates that a central bank is in no rush to change.

Booming asset prices have been accompanied by a collapse in market volatility. This has encouraged many, notably Pimco, to sell option premiums as a way of augmenting returns. This is a profitable endeavour – so long as calm waters prevail.

Mr Kastner says Fed policy has driven investors into areas of the market and exuberance that typified the end of the last boom in 2007. But he worries that changes since then have exposed retail investors to greater excesses with credit derivative securities being packaged into exchange traded funds and how small investors are now able to invest in illiquid hedge fund strategies. He also contends that junk bonds and the bank debt market "is approaching bubble territory".

Read MoreFed slaps stocks with unusually targeted comments on valuation froth

The greatest reason to worry about all these developments is that when investors seek an exit, any crowding of the gate will send markets into a tailspin, as we saw in 2008 and also for tech stocks in 2000.

Having told investors that the Fed wants a stronger economy and higher inflation before policy tightens, Ms Yellen faces the prospect that asset prices will rise further and ignore her powers of persuasion to deter the reach for yield.

Only a genuine inflation scare can alter investors' mindsets, but by then any major market reversal could well damage the economy and central bank credibility.

—By Michael Mackenzie, Financial Times