Interest rates have been low for a long time now, which a lot of people feel in their gut should lead to inflation. There hasn’t been, but the feeling is there.
As I wrote in “What The Inflation Contrarians Get Right and How to Fix It,” one common line of argument is that basically, if you only focus on the categories of goods for which prices are rising faster-than-average, then inflation really does look high. This is a totally valid observation about American society — healthcare, childcare, and related goods really are becoming less affordable. But that’s not what inflation is.
Also not inflation is the thing that some people, including major investment managers and venture capitalists, have taken to calling “asset price inflation.”
As a literal-minded person, this always drives me a bit bananas because economics is a technical subject that has technical jargon and the jargon means things. Asset prices going up is not a kind of inflation, just because by definition, that’s not what inflation is.
But there is more to life than semantics, so it’s worth spelling this out as a policy argument as well. But first, semantics!
Why financial assets are not in inflation
A Tesla Model 3 is a car, and the price of cars is in the consumer price index because cars are consumption goods.
In its factories, Tesla now has these giant die-casting machines that can craft the underbody of the car in two big pieces.
Giant die-casting machines are not consumer goods, so their price is not in the Consumer Price Index — though of course dynamics in the world of machines that make cars have an influence on the price of cars. But there are other things, like the Producer Price Index, that do count capital goods. And of course everything that counts in GDP (including business equipment and exports) is counted in the GDP Deflator.
But while the price of a Tesla is in a consumer index and the price of Tesla’s machines is in the Producer Price Index, the price of Tesla stock is not in any inflation index. Why not? Well, because it’s not the price of anything in particular. It’s just a financial claim. It’s not like investing in oil futures where there’s a physical barrel of oil underwriting the asset. Of course, Tesla has physical assets. But the prices of those assets are already in the GDP Deflator.
And if you think about other financial assets, you’ll see it doesn’t work. When interest rates fall, the price of old bonds with the old interest rates goes up. Except this actually happens so mechanically that the way we talk about bonds is in terms of their “yield” — which is to say their interest rate relative to their face value. So when interest rates go down, yields fall. That way you can compare different bonds to each other in a meaningful way. But then you’re just in tautology territory — low interest rates are identical to high bond prices; they’re not “causing bond price inflation.”
Last, foreign currency. Sometimes the value of the dollar falls. Which is to say the price of foreign currency rises. Now here’s the thing: Since Americans buy things from abroad, a rise in foreign currency prices could lead to inflation (i.e., rising consumer prices). But we measure this by looking at the prices. If foreign currency gets more expensive but prices of consumer goods don’t rise, what sense is there in saying the inflation “showed up” in the price of the financial asset? You’re not conveying any information about the economy.
What about housing, you dummy?
Noah Smith speculates that the real issue here is just that housing costs have soared in the Bay Area, so a lot of tech people think there is secret inflation when it’s really just local inflation.
I am not so sure. I talked to a guy the other week who complained to me that housing CPI is fake because it’s based on the cost of renting rather than the cost of buying a house. And this is definitely a place where the economic data bureaucracy is at odds with how normal people think about the world. The way the BLS sees it, housing is a service and everyone who isn’t experiencing homelessness is purchasing that service from a landlord. If you happen to be your own tenant then that’s an interesting fact about you, but it doesn’t change the economic picture.
If living in owner-occupied housing were something eccentric that’s only done by farmers and weirdos, this would make perfect sense to everyone.
But most Americans live in owner-occupied housing. So it is very odd to say that one of the main items in the consumer price index is rent, a price that most people don’t pay.
Of course it’s perfectly intuitive to say that rent is a huge deal, price-wise, for renters. But most people aren’t renters. Nonetheless, the BLS says that my single largest monthly expense is the rent that I pay to myself in my capacity as my landlord. This sounds extremely dumb and it makes it seem sensible to think of the sale price of houses as, in some sense, the “real” one.
Stop, though, and think for a second about why we care about inflation at all. You’ll see why it counts rent rather than sale prices.
Inflation is bad
The key thing about inflation is that it’s undesirable. If you look at two different countries whose nominal GDPs rose by the same amount, you might think their economies were doing equally well.
But if it turns out that one country had 3% inflation and the other country had 1% inflation, you’d see that the lower-inflation country was actually growing much faster. And the issue here isn’t that 3% inflation per se is any kind of “oh no it’s back the 70s!” disaster. Three percent inflation is fine. But we’re interested in inflation as a subject because if you don’t adjust for inflation, you’re not getting a correct picture of living standards.
So back to housing. If you get a 2% raise but your rent goes up 7%, that’s bad. That’s inflation. Your real living standards are falling rather than rising. By contrast, if you get a 2% raise but the value of your house goes up 7%, that’s good. In fact, you’re not likely to say “but” the value of your house went up; you’ll say and the value of your house went up. Not only did your income rise, but your net worth rose, too!
Now a situation that can arise is that rents rise by 7%, and therefore the price of owner-occupied housing also rises by 7%. This is going to be a tricky political situation, because it’s ruinous inflation for renters but homeowners will likely perceive it as a good thing. That makes it challenging to adjust housing policy in an appropriate way to combat inflation.
But the “asset price inflation” hypothesis is that the value of owner-occupied housing goes up but the rent doesn’t.
So who’s mad about that? Nobody! It’s just good. And that’s why the point that “asset price inflation” isn’t a kind of inflation at all is more than a mere semantic point. Inflation is the name of a negative thing. You need to adjust nominal figures for inflation or you’ll be too optimistic. Nobody says “yes I got a raise, but on the downside, my net worth also went up a lot.” There’s no reason you’d ever want to make a downward adjustment to your assessment of living standards to account for the fact that asset prices rose.
This matters for policy
Ultimately, the reason we care about this is that we care about policy implications.
I would be happy, personally, if Jay Powell handed me $20,000 tomorrow. But I can’t think of any politically defensible reason for him to do that. But maybe he could hand everyone $20,000 so it would be fair. Then we’d all have more money and be happy.
Okay, but it sounds a little nutty.
So why is it nutty?
Well, if it led to a huge surge in consumer prices — i.e., inflation — that would be a significant downside to the policy and very possibly a reason not to do it.
But if Powell could give me $20,000 and you $20,000 and everyone else $20,000 without prices rising, that would be amazing. You could end poverty!
“Sure we could end poverty, Mr. Chairman, but it would also create a stock market boom so let’s not do it” isn’t much of an objection. That’s a fundamentally different diagnosis than “yes people would have more money but runaway inflation would eliminate their purchasing power.” And it does no good to try to say they’re two versions of the same thing.
This is even more true when you consider that people worry about inflation because it erodes the value of accumulated savings — asset prices going up doesn't erode savings; in fact, it usually does the opposite.
Weird shit happens in good times
Here’s something that I do think is true.
When the economy is doing really badly, even a really banal business investment has a decent chance of failure. That’s bad. In fact, it’s just another way of saying the economy is bad — lots of businesses are failing. What’s true, though, is that as an investor, reward is typically proportional to risk. So if you have a good economy and boring, easy-to-understand investments are very safe, they are also unlikely to be very lucrative.
In a really well-stimulated economy, investors with an appetite for risk find themselves making bets on exotic ideas like Bitcoin and now NFTs.
One way of looking at this is people will say “is Bitcoin a bubble?” or “are NFTs stupid?”
But I think from a policy perspective, the point is that no matter what you do, there is going to be some zone of risky speculative investments. And what you want is a world in which the risky speculative investment zone is also genuinely weird and potentially innovative. If doing something sensible like opening a dry cleaning shop in a strip mall counts as a high-risk/high-reward investment, then your policy has failed. If people with a high-risk appetite are investing in a thousand crazy ideas, then maybe three of them will actually be genius and you push the frontiers forward.
Again, that is just to say that I don’t think it’s wrong to believe that the strong fiscal and monetary response that we’ve seen over the past 12 months is driving a certain amount of zaniness. But to characterize the zaniness as inflation misses the point — inflation is bad, and booming investment (including zany investment) is good.
You claim that if rents are stable and housing prices go up, no one is mad. But you're apparently forgetting about a pretty significant group of people: those who currently rent but would like to own, which I imagine is a pretty large group of people, and probably over-represented in the urban millennial influential demographic.
Our system generally makes it cheaper to own than rent (partially from the risk premium for owning, partially from the mortgage interest tax deduction). So being locked out of the homeowner class due to rising prices on homes seems like real economic harm.
You're taking the term "asset price inflation" a little too literally here. This term came about to describe the fact that despite the Federal Reserve pumping trillions of dollars into the markets via QE for decades and repressing interest rates below r-star, and that while the money supply has grown substantially, you haven't seen that show up in any form of consumer price inflation. However, what you have seen is asset prices rise substantially. To your point, this normally may be seen as a good thing. However, it's really only a good thing when they rise for fundamental reasons, in this case we have seen a broad reduction in risk premiums as the result of Fed (and global CB) policy. This has been taken to a bit of an extreme with valuations on US stocks approaching record levels and spreads very tight for fixed income products. This may not be the worst thing in the world if "traditional" inflation stays low permanently and the Fed will permanently hold interest rates low (I'd argue it's bad if the Fed is engaging in financial repression though). However, if you think that rates may rise at any point in the near future, all that you have done is form a massive asset bubble that will ultimately wreak havoc on the rest of the economy, and all you have done is cause inequality to rise in the meantime without providing any gains to "Main Street". Hence, you've seen a greater emphasis by other CBs globally such as the RBNZ and PBOC to pay attention to any distortions they may be causing in the financial markets, which I think the Fed should pay more attention to.