Predicting next asset bubble

The recent quantitative easing announced by the US Federal Reserve to pull out the US economy from double dip recessionary forces have created doubts in other central banks.

The US economy has been in the clutches of great financial crisis since 2007 and the confidence has been shattered amongst the Americans. Due to this money multiplier has plunged from about 9 to 5.5. Money multiplier depends on the percentage of loanable funds which banks mandatory need to keep with themselves, funds which banks keep extra as a buffer and percentage of funds which public keep with themselves. money multiplier falls when there is low confidence in the market and hence funds mobilized by the federal reserve are not able to reach corporations, the intended audience. There is not much fed can do to increase the money multiplier. Money supply is defined as multiple of money multiplier and monetary base (Fed's balance sheet). The quantitative easing is buying the medium term bonds from the market and flooding with money and hope that money is circulated in the economy to reduce the credit crunch.

Due to increase in the money supply in the economy, the medium term interest rates (7-10 years) fall down, which reduces the cost of capital for the corporations. Add to this the Federal Reserve has reduced the fed fund rates to near zero, which has flattened the yield curve. This provides opportunity for the fund managers to raise low cost debt to finance the industrial operations in the US or invest FDI in other high yielding economies.

On the other side,  the inflationary pressures in the emerging countries have been increasing. To curb the inflation, the central banks have been increasing the interest rates. Due to this differential in interests high amount of carry trade is possible. This has fueled the equity markets and other asset prices in the emerging economies. Though emerging economies are registering life time peaks in the equity markets, the foreign money might be fueling asset bubbles. Unlimited low cost money can be invested in only in limited investment opportunities. Once these limited opportunities are exhausted, the asset managers, under pressure to produce higher returns, invest in poor investments.

Similar capital flows happened prior to Asian Financial Crisis of 1997 when risk aversion of asset managers to fell due to higher expected returns and pushing up the asset prices.The currencies are getting appreciated and countries are being forced by the exportes to maintain the currency at 'optimum levels'. Exporters usually have good relations with the govenment to pressurize the officials.

It is in the interest of the recipient nations to receive the money, in real and financial assets, since it creates more jobs. But this can parallel increase the risk of asset bubble formation. Countries are in the dilemma to impose capital controls. The equity markets, real estate, currencies, gold are potential victims for bubble prices.