Will real inflation hold up? Why paying attention to asset price inflation matters to investors

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By now, almost everyone knows that the massive amount of financial stimulus from central banks and the government has pushed up all asset prices. But the Fed and the rest of the central banking community vehemently deny, at least publicly, that the apparent scum in all markets (stocks, bonds, credit, real estate…) is a matter of concern, as long as it doesn’t. there is no inflation.

In particular, they now all rely on Modern Monetary Theory (MMT) which says that as long as there is no inflation, a sovereign government can and should print unlimited amounts of money to solve problems. economic, financial and social. And to prove that there is no inflation, they point to the CPI (consumer price index), the PPI (producer price index) and the PCE (personal consumption deflator ). It is not important for the reader to know the details of these indicators, except that none of them contain the prices of financial assets. In other words, they monitor price increases in the price of a carton of milk or a dozen eggs, not the value of a house or a title.

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But shouldn’t asset price inflation be included in inflation measures? One of the reasons for including it would be that people with the capacity to own financial assets (typically the “rich”) primarily use asset prices to store value. In the future, when they need the money, they can liquidate some of the assets to pay for ordinary goods and services. So to exclude inflation from asset prices is to say that the only thing that matters to people’s lifestyle decisions is what they will consume today and tomorrow, and maybe next year. It also assumes that ordinary people are not very smart and do not know how they make decisions based on prices. For someone who has assets, it just makes good sense that if the pressure were to arise, they might or want to sell some of those assets to pay for food, gas, shelter, etc. At least I think I would answer.

Almost fifty years ago, a relatively unknown article by Armen A. Alchian and Benjamin Klein was written with the simple title “On a Correct Measure of Inflation”, making essentially the same point. Alchian and Klein began with the assumption that ordinary people are neither nearsighted nor stupid and do make decisions with possible outcomes in mind, even in the distant future; that is, a lifelong approach. Yes, they’re not perfect, but ignoring that they’re considering the long-term results of their choices just doesn’t seem right.

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A big technical problem with including asset prices in inflation measures is that, since asset prices are very volatile, they would make inflation measures very volatile (see chart below), thus making the inflation measures very volatile. which would make it much more difficult for policy makers to observe a number that they can then target. with real-time monetary policy, such as raising or lowering interest rates. But that’s the nature of the beast and making a metric or two paramount over everything simply ignores the complexity of the real world, a world in which asset ownership is increasingly democratized. We can’t just choose a simple metric because it makes our lives easier, especially if the well-being of the world depends on it. The inclusion of asset price inflation in traditional inflation measures makes the measure noisier, but is that a good reason to continue ignoring asset price inflation when the Fed and the economy react to inflation and deflation in asset prices? When it comes to social costs, oversimplifying the resort is a recipe for disaster. As the saying goes: “not everything that is worth measuring is not measurable, and not everything that is measurable is not worth measuring”, and if asset prices are a determining factor Important to the economy, financial stability and the Fed’s response, I think he should place more emphasis on the metric that sets policy.

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In the craze for precise measurement, the real swollen baby was thrown out with the bathwater. I sense a certain physical urge on the part of macroeconomists in their efforts to make economics like Newtonian physics with a few simple equations. But since people in the mood, mania, and panic are economics and markets, and not lifeless of thoughtless atoms and molecules, it seems silly to try to bring economics back to physics.

This coin shows the consumer inflation rate as measured by the PCE in green, and an inflation rate adjusted using the Alchian-Klein approach of weighting inflation with the growth rates of prices. assets for different weightings. The adjusted asset price metric is more volatile than the “pure” consumer inflation metric. Source: LongTail Alpha

In practice, the markets already know that the Fed is targeting stock prices even if they are volatile. A sharp drop in stock prices creates fear and could lead to deflation, recession, and maybe even depression. The response has been to face the fear of economic recession through financial repression. While the unwavering support for keeping interest rates low and asset purchases remains on autopilot, savvy investors have already begun to build protection for the ultimate unwind and pivot. Investors know that at some point, not too far away, real inflation could catch up with asset price inflation, or that asset prices could catch up with a deflating economy and when that happens the Fed will have to scramble to catch up. And yes, if a correlated collapse in stock and bond markets causes asset-price-adjusted inflation measures to deflate, the Fed will likely have to take negative rates and buy even more assets, maybe even stocks. This is how it always works.

For now, the makers have started to paint themselves in a corner. The problem with being cornered is that the only way out is unpredictable action. The markets are bracing for this and savvy investors will start to build a serious defense in their portfolios. Either that or we get by and hope, as with March 2020, that the markets will rebound within a reasonable time frame. As usual, it’s important to remember that you can’t get anything out of nothing. If we dream of driving asset prices up to the moon without something going wrong in the economy sooner or later, don’t blame the flawed indicators. And don’t count on the Fed to bail us out over and over again. One advantage of poorly specified inflation measures is that for those who can see through the mirage, opportunities abound.

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