One of the persistent themes since 2008 is the theory that there has been excessive “asset price inflation”. I’ve talked about this quite a bit before, but it is worth repeating. And no, “assflation” does not refer to the 19 lbs we’ve all put on during COVID. It refers specifically to the term “asset inflation”. This is the idea that the “inflation” that was supposed to show up in consumer prices has been showing up in asset prices like stocks and housing. There’s a bit of truth to this, but let’s discuss this in more detail so we can keep things in the right perspective.
Capital Goods vs Consumption Goods
It’s important to make a clear distinction between capital goods and consumption goods in the context of the term “inflation”.
A consumption good is something that you literally consume. Its value erodes (or disappears) because you consume it over time. For instance, when you buy a cheeseburger for $10 you temporarily have an asset that is worth $10. But you immediately consume that cheeseburger and your $10 asset disappears.¹ If you have to buy another cheeseburger tomorrow for $20 because of consumer price inflation then you are worse off than you were yesterday because you now have less to spend on other goods and services. The seller of cheeseburgers might be better off if they have pricing power, but the more important fact is that you are definitively worse off if the only food you consume is cheeseburgers. Since everyone has to eat everyone is worse off except for the seller of cheeseburgers.
A capital good is something that results from investment, but does not necessarily get consumed (or holds its value over time). For instance, if you built a house for $100,000 you would buy many material capital goods. Those physical capital goods might depreciate over time, but they might also appreciate over time. The kicker is that you don’t necessarily consume them in the same way that you consume a cheeseburger.
So, if someone visits your house tomorrow and believes that that $100,000 pile of wood is worth buying for $200,000 then you are not worse off. Importantly, neither are they. They will own a $200,000 pile of wood and you have $100,000 more than you previously did. If you have to purchase another home you theoretically have just as much purchasing power in your neighborhood as you did before. You actually have more purchasing power relative to other assets (assuming they have not appreciated 100%).
The main difference in these two examples is that the consumer price inflation is an absolute cost that impacts virtually everyone in a negative way whereas the capital goods inflation makes many people better off in an absolute sense and some people worse off in a relative sense (for instance, first time home buyers who feel that they cannot afford the $200,000 houses). Of course, these people who choose to rent are not worse off in absolute terms. In fact, renting might be the absolute better choice for them depending on their specific situation (unless of course there was also consumer price inflation resulting in a 100% increase in their rent every year).
What About Inequality and Asset Bubbles?
The primary concern with “asset inflation” is asset bubbles. For instance, let’s say that the Fed is implementing policies that, in their own words, are designed to keep “asset prices higher than they otherwise would be”. One could easily envision such a policy turning into an environment where investors bid up asset prices in an irrational manner in which the intrinsic value of asset prices are materially detached from their market prices and unsustainable. This is a legitimate concern in my opinion and one that I think you could argue has occurred at times in the last 10-20 years.
Importantly, this isn’t “inflation” in the proper sense of the word. Inflation is generally an absolute negative because it causes the things we consume to become more expensive to replace. A very high inflation occurs during periods of highly traumatic and damaging economic environments. A capital goods inflation, on the other hand, typically occurs during economic booms and as I alluded to above, it is most damaging during very good economic periods when people become irrationally optimistic about the future.
What About Market Efficiency?
The core problem with the “asset inflation” view is that it really becomes a market efficiency debate. That is, if the Fed is driving investors to irrationally bid up asset prices then that must mean that prices are inflated in the short-run and likely to mean revert in the long-run. But if this is your view then what do you care? It simply means that prices are temporarily higher than they otherwise would be and will eventually crash when markets come to their senses. Unless of course you believe that asset prices are perpetually manipulated in which case you also shouldn’t care because you don’t think they can ever collapse which means you should just be an owner and “don’t fight the Fed”. While I am not an efficient market person I also have a hard time believing that markets are so inefficient that they would never sniff out a complete manipulation of the entire system.
The strangest contradiction here is that the “asset inflation” narrative seems to come exclusively from people who are bearish about these assets. So, they’re certain that the Fed is manipulating prices and they’re certain that asset prices will go up because they claim these policies can never end, but they’re bearish about these assets at the same time. This doesn’t even make sense.
In any case, I would argue that most of the asset price appreciation of the last 10+ years appears largely rational in the sense that it is supported by corporate fundamentals (record profits, record GDP, etc) and other robust economic data that is consistent with a growing economy. It isn’t just a fictitious boom as many “asset price inflation” narratives like to imply.
As for inequality – asset price inflation would tend to exacerbate inequality since it will disproportionately benefit those who own assets. This makes sense. But as I like to always point out, inequality is a policy failure, not a market failure. After all, a capitalist economy will always veer towards monopolistic behavior if we allow it to. The extent to which we allow that to happen is not a failure of capitalism, it is a failure of policy makers to contain capitalism.
Was it Fiscal Policy or Monetary Policy?
One common theme with the debate about QE is the assumption that Monetary Policy causes certain asset prices to rise when Fiscal P0licy explains much of the asset price increase. For instance, we know that government deficits add to corporate profits. The Kalecki Profits Equation teaches us:
Corporate Profits = Investment + Dividends/Buybacks – Household Saving – Government Saving – Rest of World Saving
This is why the stock market often rises after government stimulus. But it is not merely the Fed’s involvement that causes this. In many cases it is the strong fiscal response and government spending that leads to an increase in corporate profits and stock prices.
What About Interest Rates?
Another common theme with QE is the idea that QE causes interest rates to be lower than they otherwise would which thereby causes asset price inflation through the interest rate channel. But this misses the whole point of QE, which is to boost consumption and ultimately stimulate the economy. If QE worked the way most people assumed then it would cause HIGHER consumer prices and HIGHER interest rates because the Fed would ultimately have to raise rates to slow the economy. In fact, we’ve seen the exact opposite for 10 years running. QE appears to stimulate the economy only modestly and so rates have remained low because the Fed believes the economy remains too weak.
One interesting side effect of QE is that it reduces private sector interest income by removing bonds from the economy. This means that interest income has fallen even though QE maintains the same quantity of net financial assets. In total we would expect this to be mildly deflationary because private sector incomes decline, all else equal.
The Monetary Policy transmission mechanism is complex and multi-faceted. There’s no doubt that, in certain cases, the Fed can cause asset prices to rise. But this issue is often much more complex than many of the market narrators make it appear.
That’s my brief view on the “asset price inflation” debate. I hope it helps a bit.
¹ – Cheeseburgers are my personal favorite if one is on the assflation diet.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.