The most important debate in economics right now is the question of whether low interest rates in the US, UK and Europe are creating yet another bubble that will eventually pop with disastrous consequences. A new note to investors from economists at Morgan Stanley argues that yes, it is possible that the US Federal Reserve, the Bank of England and the European Central Bank are causing as-yet unseen inflation via their policies of holding interest rates at 0% for extended periods. Its title is: "Could We Be Underestimating Inflation?" First, the context. You can be forgiven for not noticing that a bubble might be happening because it isn't causing classic money-inflation. It's inflating assets instead. Money inflation, or monetary inflation, is scary because it makes you instantly poorer, as the price of everything around you goes up. There is only one good thing about money inflation: you can see it happening, every day. And it is easily fixed: central banks can raise interest rates sharply, making money expensive to lend or invest. When money becomes harder to get because it is more expensive to borrow, then inflation disappears pretty quickly. But people don't feel scared when assets get inflated. For one thing, assets don’t all rise in value at the same rate. Stocks may be at historic highs right now, but the price of oil may be at historic lows. And, frankly, asset inflation feels pretty good. Your stock/retirement portfolio suddenly looks very tasty and it's great that your house is suddenly worth so much money! Asset inflation is fixed the same way that money inflation is fixed: you raise interest rates, and all the cheap money that flowed into those assets suddenly starts flowing out again, especially when banks and bonds start to pay more than 0% interest. The problem — as we all learned in the 2000 dot com crash and the 2008 credit crisis — is that a collapse in asset inflation is painful for those left holding assets that are suddenly worth zero. (Assets are less liquid than cash, so when they fall they tend to fall hard. Think about property prices in 2008-2009.) Yet few people understand this debate, despite the fact that everything — literally everything — depends on the answer to the question Morgan Stanley poses. Here are some examples of what we're talking about: Private equity-backed tech companies are currently in the middle of an enormous boom. It's not on the scale of the 2000 dot-com bubble, but the number and value of deals is fast-approaching that size, according to these stats from PwC: Yet, within the tech world, people aren't screaming about interest rates. They are mostly enjoying the fact that there are 102 unicorns in the world. Unicorns are tech startups valued at more than $1 billion. They used to be rare. Now there is a new one every week. No one knows how many of them are profitable. We've also got full employment in the UK and the US, and signs of fierce price rises in property in London, Norway and Germany. Moody's, the credit rating service, recently all-but said the European Central Bank is blowing a new housing bubble in Europe. The central banks, however, are holding rates at zero. They are doing this because they believe that economic growth is weak. It’s certainly weak in Greece, Spain and Italy. So the ECB has an excuse for keeping the euro cheap even if growth in Germany is just fine. But the UK, Germany and the US all have close to full employment. Their economies look strong. And yet their banks also have 0% effective rates. Morgan Stanley’s Manoj Pradhan and his team decided to look for signs of inflation, they said: If our thesis is right, the upside risks to inflation that we highlight could materialise over the next 12-18 months and even beyond. Our thesis in a nutshell: the US, UK, Germany and Japan could show inflation surprises to the upside in a specific, nuanced and sequenced story because they have three common dynamics: i) labour markets are either already tight (except in the US now) or will almost certainly be universally tight in 2016; ii) housing markets in all four economies are doing well, giving breadth to the economic expansion because the housing market tends to lift more parts of the economy than most others; and iii) central banks in all four economies are unlikely to remove monetary accommodation in a way that jeopardises growth. In doing so, they are likely to encourage even more tightness in the labour and housing markets, paving the way for a pick-up in wages and compensation, and housing rents and prices They discovered these inflationary factors: inflation from wages and housing in US, UK and Germany But! deflation in the US from a decline in healthcare costs post-Obamacare deflation from cheap imports to US fueled by strong US dollar deflation from weaker areas of Europe (Greece, Italy, Spain) Frustratingly, Morgan Stanley came to a nuanced conclusion rather than a slam-dunk verdict: On the arguments we provide above, inflation measures may not adequately capture inflation. This may mean that more monetary accommodation than is ‘right’, or feedback from asset price inflation leads to more spending than would occur when inflation is correctly measured. Nonetheless, for bubble-watchers, Morgan Stanley raises a really interesting question: why the heck are interest rates at zero when the world's major western economies are at full employment? And why isn't that inflationary?Join the conversation about this story » NOW WATCH: You've been rolling your shirtsleeves wrong your entire life
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