Regarding the signaling capability of equity prices, Fed Chairman Greenspan has
undoubtedly considered the possibility that the extraordinary rally in equity prices seen
over the past 3-1/4 years could imply that the Fed is supplying too much liquidity to the
economy. Japan's lesson in this regard is worth recalling.
The Bank of Japan in the late-1980s was faced with a bubble in asset prices which was
not recognized at the time because the measured CPI remained relatively well behaved.
The BOJ assumed that monetary policy was correctly calibrated because the CPI was not
flashing any serious warning signs. However, Japanese consumers and businesses were
in fact piling their excess liquidity into assets such as stocks and land, not into goods
and services where the excess demand would have shown up in the CPI statistics. By the
time the BOJ realized that liquidity was excessive, the stock market and land prices had
been bid up to astronomical levels. When the BOJ finally curtailed its easy monetary
policy, the result was a collapse of the asset price bubble. To this day, Japanese stock
and land prices are still 50-60% below the highs reached in the late 1980s during the
height of the asset bubble.
While the US is certainly not facing an asset bubble of any comparison to Japan, it is
still worth considering that the Fed may be unintentionally supplying excess liquidity to
the economy that is finding its way into the stock market.