Three Monetary Riddles for the New Year

Three monetary riddles, partially overlapping, require at least a tentative solution before work on any genuine forecast for 2026 and beyond should begin. The completion of the forecast depends further on the taking of a view about the pre-election US monetary stimulus policy of 2025-6. How will this rank alongside previous episodes of the same phenomenon including the Nixon shock of 1971/2, the Volcker/Baker devaluation policy of 85-6, and the Bush/Greenspan devaluation and near zero rate policy of 2003-4.

First riddle: How can a powerful and record-long asset inflation go into reverse when the Fed is implementing a program of monetary stimulus?

This riddle is highly relevant to actual market discussion about similarities between the AI boom and the dotcom bubble. The latter burst in the context of the Greenspan Fed in 2000, regardless of the approaching elections, tightening monetary policy. This got under way once it became clear that the feared crisis related to the Y2K computer problem had not emerged.

The NASDAQ crash of 2000 might not have happened if the Fed had continued to administer inflation injections up until Election Day. Crash postponed, however, is not Crash avoided. A Fed which continues to administer monetary injections in an Election year may start to tighten policy soon after. The trigger by then could be an upturn in reported CPI inflation. Or alternatively, in principle, malinvestment and financial fragility may have become so apparent that the bubble music comes to a stop.

In practice, the Great Crashes coupled with Great Recessions of the last 100 years – 1929/33, 1937/8, 1973/5, 1981/2, and 2008/10 – have all been preceded by monetary policy tightening. In the first two cases a key motive for Fed tightening was to cool a speculative stock market boom; in the latter two it was concern about goods and services inflation. 

So, does the present apparent monetary stimulus from the Fed mean there will be no early sustained reversal of asset inflation? The laboratory of history, though, is too small to justify bold prediction on this point. The present monetary inflation without break is the longest on record. So historical evidence only goes so far. Further, essential doubts can emerge as to whether outward appearances of monetary stimulus are correct. That possibility leads on to riddle number 2 facing the forecaster at the start of 2026.

Second Riddle: How can monetary policy seem easy and stimulatory and yet in reality be tight and disinflationary?

There is no longer a reliable diagnostic tool for recognizing monetary inflation or deflation. The use of that tool depended on measuring the divergence between supply and demand for monetary base. “Thanks” to deposit insurance, too big to fail, and the war on cash, base money no longer renders services of intense moneyness (as medium of exchange or store of value) which are large relative to economic size. The payment of interest on reserves at the policy rate has made the problem of diagnosis even worse as at the margin of their holdings of monetary base individuals or businesses are deriving no intense monetary services.

Counting up the rate cuts or rate rises is not a recipe for reliable monetary diagnosis. The present advocates of the Fed continuing to cut its policy rate maintain that we should ignore the fall in the (domestic) purchasing power of the dollar brought about under the “transitory” influence of tariffs. Accordingly, the “underlying” rate of inflation is below 2 per cent and in parallel the “neutral rate of interest” could be 3 per cent.

Under a sound money regime, however, a switch to indirect taxation (such as tariffs) from direct taxation of incomes (in a so-called revenue neutral way) would not give rise to a loss of money’s purchasing power. Demand for money in real terms would be unaffected, and the supply of monetary base (whether gold or fiat) would remain on an unchanged path. Ex-tax consumer prices and nominal wages (now subject to less income tax) would fall

An initial pass through of indirect taxes to prices would mean that households and businesses find themselves holding less money in real terms than previously. Correspondingly they would enjoy less of the intense money services as rendered by base money. In response they cut back spending on non-monetary goods and services, causing their prices to come under downward pressure. 

The pass through of indirect tax to higher prices (and lower purchasing power of the dollar) which has actually occurred is suggestive of monetary inflation under the present unsound regime. In fact, a glut in oil (WTI price down 20% in year to end-2025) and a spurt in productivity growth (as hypothesized by the AI enthusiasts with a little supporting data albeit very noisy) would mean under a sound money regime a period of prices in general falling to a lower level. The actual significant further loss in the dollar’s purchasing power through 2025 is suggestive of monetary inflation as corroborated by still rampant asset inflation.

There is a counter-case to consider, though less plausible than the case of monetary inflation.

Asset inflation may appear vibrant, but it could be a lagging indicator of overall monetary inflation. There are patches of asset market inflation fading or worse – including evidence from some real estate markets, the slump in the fine art market, the seizing up of the private equity market. And much of the overall rise in the S&P 500 in 2025 simply matches a devaluation of the dollar.

As regards consumer prices, lags are notorious. A key area of actual concern here is the inability of CPI compilers to promptly recognize falls in house prices – via the components of imputed owner rents or actual market rents. This lag on house prices though is not likely to negate the earlier mentioned evidence of monetary inflation in goods and services markets.

And on the subject of lags which thwart the timely diagnosis of inflation or disinflation, we come to the third riddle which makes forecasting so difficult.

Third Riddle: Monetary inflation – and the disease of asset inflation which it spawns – brings a build-up of mal-investment. Could this become so serious as to mean a widespread decline in prosperity?

To many of us brought up to marvel at technological change, this may seem an odd riddle. Yes, the speculative frenzies of asset inflation and the receding of rational caution might lead to an acceleration of technological change. We are conditioned to think of this as a Good Thing in the End, even though there may be transitory excesses and avoidable mistakes along the way. 

On examination, though, that Good Thing may be a delusion Greater caution may have meant more time for flaws in the new technology to emerge before it had so penetrated the commercial landscape as to become irreversible. Slower penetration may have made it easier for the next big innovation to catch on and become commercially viable and that might have had benefits compared to a long period with the in-the-end-not-so-wonderful technology having become dominant. 

Riddle three and its possible solution lead back to riddle one. Can asset inflation end without an initial spell of monetary disinflation?

Yes. And one way is for the accumulating malinvestment just to become so burdensome. Total factor productivity, which takes account of the capital which the new innovation requires to boost labor productivity, might even turn negative – especially if measured in a way which takes account of the destructive forces unleashed.