The question often comes up: with all of the loosey-goosey monetary policy, historically low interest rates, liquidity injections and quantitative easing, why haven’t we seen huge bouts of price inflation?
Some people then take the next step and suggest that since we haven’t had huge bouts of inflation, this kind of loosey-goosey monetary policy should become the standard. With unlimited money at our fingertips, we can all have the proverbial free lunch.
Wolf Richter says there is a fatal flaw in this plan. Despite what the pundits tell you there have been huge bouts of inflation — “Pernicious, dangerous inflation.”
The inflation Richter is talking about is less focused on the price of consumer goods and more about the increase in asset prices. We usually just call it “bubbles.”
Assets – stocks, bonds, commercial real estate, residential real estate and so-on – are highly leveraged. When their prices rise, they are used as collateral for more debt. This means banks and bondholders are on the hook when prices turn the other way. This can lead to a banking crisis and then a financial crisis. We saw this scenario play out when the housing market crashed in 2006-2007 precipitating the 2008 financial crisis.
Richter explains asset inflation using the simple case of a home. Say you bought the house in 2019 for $200,000 in then sell it in 2019 for $300,000.
It doesn’t mean that the house grew 50% in size or got 50% more opulent … Nope. The house stayed kind of the same, except it got a little older. But what it means is that the dollar with regards to this house lost much of its purchasing power.”
Between January 2013 and December 2018, house price inflation in the US was 42% nationally and much higher in a number of metro areas.
There’s your inflation.
This just means that it takes a heck of a lot more dollars than six years ago to buy the very same house. No magic here.”
Evaluating asset price inflation in the stock market is a bit more complex because unlike houses, companies do grow – revenues and earnings go up. But the price-earnings (P/E) ratio gives us a picture of asset price inflation in stocks. This number tells us how many dollars it takes to buy a given level of earnings.
In July 2012, the aggregate P/E ratio for the S&P 500 companies was just under 15. In simple terms, it took $15 to buy $1 of earnings. Today, the aggregate P/E ratio for the S&P 500 is about 23. It now takes $23 to buy the same $1 in earnings per share. That represents a 55% increase in asset price inflation in the S&P 500. In that same period, the S&P 500 has gained about 120%. That means nearly half of the gain is purely asset price inflation.
This type of asset price inflation, whether it’s in housing or in stocks or bonds, was the express purpose of the monetary policies during and after the financial crisis. QE was supposed to trigger the quote-unquote wealth-effect, where asset-holders feel wealthier due to asset price inflation and then start spending and investing this wealth to boost the overall economy.”
As Richter explains, asset inflation has a pernicious effect. In effect, it devalues the fruits of labor. If a house price increases by 50% due to price inflation, but the wage rate only increases by 10%, it takes significantly more labor to buy the same house.
Eventually, the bubble will burst because inflated housing prices eventually kills demand. Because homes are highly leveraged, a crash in prices ultimately hits the mortgage holders. We saw this scenario play out vividly in the mid-2000s with the Great Recession the end-result.
Stocks are also highly leveraged. A bursting stock market bubble can have a nasty impact on banks.
Asset price inflation also causes yields to fall. This means investors get less income. That drives them to take more risks in efforts to boost income.
Inflated asset prices support larger debts, but when asset prices deflate and the borrower defaults, their collateral is no longer enough to cover the debt and these lenders take big losses.”
As Richter makes clear, asset price inflation is every bit as problematic as consumer price inflation.
Asset price inflation feels good because it translates into seemingly free and easy wealth for asset holders. But when it deflates, it tends to pull the rug out from under the banks and the broader financial system, and it causes all kinds of other mayhem. Asset price inflation is not benign. It’s not a free lunch. It loads up the financial system with systemic risks and future losses.”
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