How Long Can Central Bankers Ignore Bubbles?

No one ever said a central banker's life was easy. But the balancing act required to manage the tricky scenario of falling inflation and rocketing asset prices has many a policymaker sounding nervous, and with good cause.

Having pumped the markets full of cheap cash, it would be fair to assume consumer price inflation would head higher. But inflation readings in nearly all major developed economies are well below the 2% or so most central banks target. In the U.S. and U.K. they were unchanged on the year in February. In the eurozone they'd fallen 0.3% and while Japan's most recent headline inflation reading was 2.4% the Bank of Japan recently warned that over the near term, the rate is heading back to zero.

Miserable commodities markets may be distorting those figures, of course, but that's not the only factor. Core inflation, stripped of volatile food and energy components, is weak. Other factors are weighing in, among them globalization, China's investment binge and current economic slowdown, and the after-effects of the financial crisis and crash.

But a more recent cause may be all of the banks’ own making: The European Central Bank and BOJ are exporting their structurally-driven domestic deflationary problems by devaluing their currencies through aggressive monetary policy. Pumping money into the system lifts inflation a much-needed bit, largely by making imports more expensive. But it boosts the financial economy a great deal, handing a big boost to assets from stocks to bonds to houses.

Since the ECB started hinting at QE, a program that’s now in place. Germany's DAX index of leading equities has soared a shade under 40%. Then again, equity markets everywhere have soared, not least in Japan and the U.S. As have corporate bond prices. High-yield debt is a misnomer these days--investors get risk, but not a lot of return.

In the U.K., London house prices have been a major beneficiary of the Bank of England's own quantitative easing program--they're now a third above their pre-crisis peak, itself in bubble territory. There's a clear risk that the Australian, Canadian, Swedish and Norwegian property markets are also full of froth, based on historic price-to-rent and price-to-earnings valuation metrics. And with German metropolitan property prices also rising much more sharply than they have done for decades, the Bundesbank is worried about its own incipient bubbles.

Last week Steven Maijoor, chairman of the European Securities and Market Authority, a regulatory body, warned that ECB quantitative easing risks "overvaluation in the non-banking sector." Bubbles in other words.

And on Monday, St. Louis Fed President James Bullard warned that notwithstanding low inflation, near-zero interest rates were no longer a clever idea for the U.S. economy. To keep rates this low much longer, the Fed risks inflating asset bubbles with "devastating consequences."

There is clearly a tension between the needs of underlying economies for further monetary support and overblown financial markets.

Of course inflating asset prices through quantitative easing was part of the deal. Central banks intended it to generate wealth effects and spur consumption, credit creation and thus growth. The problem central bankers now face is how to keep those increases from becoming systemically dangerous and how to normalize monetary policy without the whole house of cards from collapsing.

Some think that macro-prudential regulation--leaning against bubbles by tightening credit requirements--is the answer. To various degrees, the Canadian, Swedish and U.K. central banks are using or intend to use macroprudential tools to limit house price inflation. So far it doesn't seem to be working.

Meanwhile, the Fed is making noises about needing to start tightening policy in the not-too-distant future, but thereafter only slowly.

What seems clear is that central bankers will mostly play down bubble risks (they've seldom identified bubbles except with hindsight and not always then either) and keep their focus on the main real economy metrics: inflation and unemployment.

Whether the outcome will be better than it was the last time round is another matter.