One of the more common responses to the fact that inflation is low is the idea that the inflation is all in asset prices. So, for instance, if someone were to say that all the Fed’s post-crisis stimulus didn’t result in inflation you might look at stock prices and argue that the price increases all flowed into stocks. That’s not necessarily wrong, but I think it needs to be well understood because asset price inflation is generally good for the economy while consumer price inflation could be bad.¹
First off, we should start with clear definitions – consumer price inflation is a general rise in the price level. Importantly, when individual prices rise, such as gas prices, it does not mean there is “inflation”. It means gas prices rose. But “inflation” measures the entire basket of goods. We’re trying to understand aggregate prices instead of a component of the aggregate. So next time you drive by your local gas station and raise a fist at the rising prices don’t be tricked into thinking that that means inflation is higher since it could very well be offset by price declines elsewhere.
Consumer price inflation is constructed to measure the price of things we consume. So, for instance, if I need to drink water and it costs $1 per gallon this year then a 10% increase in the price of water could negatively impact my standard of living because the water is something I consume. The water goes away when I consume it and I can only maintain my standard of living by consuming more of it.² If I have to work the same amount to consume more expensive water then I am worse off than I previously was.
Asset price inflation is different. When asset prices rise we are generally better off than we were before. For instance, when the price of the S&P 500 rises by 10% we are that much wealthier than we were before because now we can sell something we saved for a higher value than we originally purchased it at.³
As many things do in economics, it comes to the basic accounting at work here. When I spend $1 on water I give someone else money and I get water. But the water goes away when I drink it. This was a pure expense. The asset I bought disappears when I drink it and the seller has my $1. If the cost of water goes up next year then I am worse off than I was before assuming I have to work the same number of hours to obtain the more expensive water.
Purchasing the stock is different. When I buy a $1 stock I exchange cash for the stock. If the stock goes up in value I am better off than I was before. In other words, I can buy more water because the stock went up in value and the seller has my $1. This is an increase in aggregate standards of living.4
So, the next time someone says that inflation is all in asset prices point out that asset price inflation and consumer price inflation are not the same thing and that asset price inflation can be a very good thing for the economy when it’s supported by fundamentals.
¹ – Contrary to popular opinion, inflation is totally normal in a credit based economy because the money supply is always increasing over time. This isn’t necessarily a sign that our living standards are declining though. For instance, if I borrow $100,000 to buy a house then I might bid up the price of the home and the cost inputs. This could result in higher prices, but it will also result in higher profits and hopefully higher wages for the workers of corporations. If all of this results in a 2% rise in inflation AND a 2% rise in wages then we are no worse off than we were before because we have to work the same number of hours to afford the same quantity of goods.
² – “Living standards” are tricky concept of course. Economically speaking, it’s safe to argue that our living standards are improving when we are spending less of our current income on economic necessities. That is clearly the case in the post-war era.
³ – This gets a little muddled with house prices because they can be both consumption and investment. A home is really a depreciating asset on an appreciating piece of land. It is both something we can consume and invest in. Most people will never calculate how much their home actually costs them because they won’t accurately account for the total costs that go into maintaining that depreciating asset. On average, homes are far worse long-term “investments” than most people think because the input costs that contribute to maintenance costs have a significant negative impact over the course of time. In other words, homes are extremely expensive assets to own. The BLS accounts for this in their inflation measures by calculating Owner’s Equivalent Rent which reduces some of the variance in home prices due to investment and the misconception that single family homes generate high returns.
4 – There is an important caveat here. Stock price increases should be supported by fundamentals (and they clearly have in the last 10 years as corporate profits have boomed). And while this is usually the case it is not always the case. Contrary to popular economic theory, humans are not always rational and can do pretty stupid things at times. We are biased and emotional so we chase prices on the upside and often overreact on the downside. So stock prices are generally a good reflection of fundamentals, but not always. And when they deviate from fundamentals it can be a sign that our living standards appear better than they really are or worse than they really are.