The economic phenomena of asset price inflation occurs when the price of assets rises and becomes inflated. Low interest rates are a common cause of increasing asset prices. When interest rates are low, investors and savers can’t make easy money by investing in low-risk instruments like government bonds or savings accounts. To receive a return on their money, investors must instead purchase other assets like as stocks and real estate, causing asset price inflation by bidding up the price.
When people talk about inflation, they usually mean the cost of everyday goods and services, which the Consumer Price Index measures (CPI). Financial and capital assets are not included in this index. Financial asset inflation should not be mistaken with inflation of consumer goods and services, as the two categories’ prices are frequently separated.
Shares and bonds (and their derivatives), as well as real estate, gold, and other capital commodities, are examples of common assets. Alternative investment assets, such as fine art, expensive watches, and venture capital, can also be included.
What is the significance of asset price inflation?
What is the significance of asset price inflation? When asset prices rise faster than their “true” value. When goods inflation is held down by globalization, it can reflect if an economy has exceeded its potential output. It has the potential to cause asset deflation, which would be detrimental to the economy.
What effect does inflation have on asset prices?
Asset Classes and Inflation Inflation affects liquid assets in the same way it affects other assets, with the exception that liquid assets tend to rise in value less over time. This means that, on balance, liquid assets are more exposed to inflation’s negative effects.
Why is asset inflation such a problem?
Most individuals are aware that inflation raises the cost of their food and depreciates the worth of their money. In reality, inflation impacts every aspect of the economy, and it can eat into your investment returns over time.
What is inflation?
Inflation is the gradual increase in the average cost of goods and services. The Bureau of Labor Statistics, which compiles data to construct the Consumer Price Index, measures it (CPI). The CPI measures the general rise in the price of consumer goods and services by tracking the cost of products such as fuel, food, clothing, and automobiles over time.
The cost of living, as measured by the CPI, increased by 7% in 2021.
1 This translates to a 7% year-over-year increase in prices. This means that a car that costs $20,000 in 2020 will cost $21,400 in 2021.
Inflation is heavily influenced by supply and demand. When demand for a good or service increases, and supply for that same good or service decreases, prices tend to rise. Many factors influence supply and demand on a national and worldwide level, including the cost of commodities and labor, income and goods taxes, and loan availability.
According to Rob Haworth, investment strategy director at U.S. Bank, “we’re currently seeing challenges in the supply chain of various items as a result of pandemic-related economic shutdowns.” This has resulted in pricing imbalances and increased prices. For example, due to a lack of microchips, the supply of new cars has decreased dramatically during the last year. As a result, demand for old cars is increasing. Both new and used car prices have risen as a result of these reasons.
Read a more in-depth study of the present economic environment’s impact on inflation from U.S. Bank investment strategists.
Indicators of rising inflation
There are three factors that can cause inflation, which is commonly referred to as reflation.
- Monetary policies of the Federal Reserve (Fed), including interest rates. The Fed has pledged to maintain interest rates low for the time being. This may encourage low-cost borrowing, resulting in increased economic activity and demand for goods and services.
- Oil prices, in particular, have been rising. Oil demand is intimately linked to economic activity because it is required for the production and transportation of goods. Oil prices have climbed in recent months, owing to increased economic activity and demand, as well as tighter supply. Future oil price rises are anticipated to be moderated as producer supply recovers to meet expanding demand.
- Reduced reliance on imported goods and services is known as regionalization. The pursuit of the lowest-cost manufacturer has been the driving force behind the outsourcing of manufacturing during the last decade. As companies return to the United States, the cost of manufacturing, including commodities and labor, is expected to rise, resulting in inflation.
Future results will be influenced by the economic recovery and rising inflation across asset classes. Investors should think about how it might affect their investment strategies, says Haworth.
How can inflation affect investments?
When inflation rises, assets with fixed, long-term cash flows perform poorly because the purchasing value of those future cash payments decreases over time. Commodities and assets with changeable cash flows, such as property rental income, on the other hand, tend to fare better as inflation rises.
Even if you put your money in a savings account with a low interest rate, inflation can eat away at your savings.
In theory, your earnings should stay up with inflation while you’re working. Inflation reduces your purchasing power when you’re living off your savings, such as in retirement. In order to ensure that you have enough assets to endure throughout your retirement years, you must consider inflation into your retirement funds.
Fixed income instruments, such as bonds, treasuries, and CDs, are typically purchased by investors who want a steady stream of income in the form of interest payments. However, because most fixed income assets have the same interest rate until maturity, the buying power of interest payments decreases as inflation rises. As a result, as inflation rises, bond prices tend to fall.
The fact that most bonds pay fixed interest, or coupon payments, is one explanation. Inflation reduces the present value of a bond’s future fixed cash payments by eroding the buying power of its future (fixed) coupon income. Accelerating inflation is considerably more damaging to longer-term bonds, due to the cumulative effect of decreasing buying power for future cash flows.
Riskier high yield bonds often produce greater earnings, and hence have a larger buffer than their investment grade equivalents when inflation rises, says Haworth.
Stocks have outperformed inflation over the previous 30 years, according to a study conducted by the US Bank Asset Management Group.
2 Revenues and earnings should, in theory, increase at the same rate as inflation. This means your stock’s price should rise in lockstep with consumer and producer goods prices.
In the past 30 years, when inflation has accelerated, U.S. stocks have tended to climb in price, though the association has not been very strong.
Larger corporations have a stronger association with inflation than mid-sized corporations, while mid-sized corporations have a stronger relationship with inflation than smaller corporations. When inflation rose, foreign stocks in developed nations tended to fall in value, while developing market stocks had an even larger negative link.
In somewhat rising inflation conditions, larger U.S. corporate equities may bring some benefit, says Haworth. However, in more robust inflation settings, they are not the most successful investment tool.
According to a study conducted by the US Bank Asset Management Group, real assets such as commodities and real estate have a positive link with inflation.
Commodities have shown to be a dependable approach to hedge against rising inflation in the past. Inflation is calculated by following the prices of goods and services that frequently contain commodities, as well as products that are closely tied to commodities. Oil and other energy-related commodities have a particularly strong link to inflation (see above). When inflation accelerates, industrial and precious metals prices tend to rise as well.
Commodities, on the other hand, have significant disadvantages, argues Haworth. They are more volatile than other asset types, provide no income, and have historically underperformed stocks and bonds over longer periods of time.
As it comes to real estate, when the price of products and services rises, property owners can typically increase rent payments, which can lead to increased profits and investor payouts.
What exactly does price inflation imply?
Inflation is defined as the rate at which prices rise over time. Inflation is usually defined as a wide measure of price increases or increases in the cost of living in a country.
Why are asset prices excluded from inflation calculations?
One major technical issue with including asset prices in inflation metrics is that, because asset prices are extremely volatile, they would make inflation metrics extremely volatile (see chart below), making it much more difficult for policymakers to focus on a single number that they can then target with real-time monetary policy, such as raising or lowering interest rates. Furthermore, because many things are tied to the inflation metric, a volatile metric would make bookkeeping for these commitments extremely difficult (averaging may be able to help, however) But that’s the nature of the beast, and prioritizing one or two indicators over everything misses the complexities of the real world, which is becoming more democratized in terms of asset ownership. We can’t just pick a simple statistic because it makes our lives simpler, especially if the world’s welfare is at stake. Traditional inflation indicators become noisier when asset price inflation is included, but is this a fair excuse to ignore asset price inflation when both the Fed and the economy respond to asset price inflation and deflation? Oversimplifying the complex when it comes to social costs is a formula for disaster. “Not everything that is worth measuring is quantifiable, and not everything that is measurable is worth measuring,” as the saying goes, and if asset prices are a key driver of the economy, financial stability, and Fed response, I believe they should be given more weight in the policy metric.
How does the price of an asset affect the economy?
Macroeconomic data tends to lag events, which means that research output to support policymakers is frequently delayed. This would be mostly insignificant in normal times, but we are not in normal times. Governments and other policymakers must make quick judgments based on accurate information.
This plays a critical role in interpreting asset price data, which is available in real time, in order to comprehend the pandemic’s implications and forecast the economy’s anticipated impact. After all, changes in asset values will have an impact on the economy’s trajectory.
Asset prices and economic activity
Any possession or resource that has value in a transaction is referred to as an asset. A more nuanced definition is that it is a claim on future cash flows, which means that the present value of those cash flows determines the asset’s worth.
The pricing of an asset is critical for allocating financial resources and avoiding inefficiencies in real-world investment and consumption. The projected discounted value of an asset’s payoff should be equal to the asset’s price (Cochrane, 2009).
Consumption and investment, in general, are the key avenues via which asset prices affect real economic activity. The ‘wealth effect,’ which often supplements the ordinary income effect, has an impact on consumption. The wealth impact is directly related to the ‘permanent income hypothesis,’ which states that consumption flows are determined by expectations of permanent income (that is, we consume the annuity value of our wealth). This frequently manifests itself in the form of price swings in assets such as stocks and real estate.
The most accurate indicator of a household’s balance sheet status is net wealth, which influences consumption decisions. Tables 1 and 2 demonstrate the household sector’s balance sheet situation in 1995 and 2015, respectively (Chadha, 2017). Also see the body of knowledge on balance sheet recessions (for example, Mishkin et al, 1977).
Table 2: Balance sheet of the household sector, 2015 (bn)
The erratic variations in current expectations of present and future risk-adjusted returns are often captured by day-to-day fluctuations in asset prices. Asset price innovations also assist us in comprehending the accumulation of both financial and non-financial wealth.
What does evidence from economic research tell us?
According to a number of studies, asset values and real economic activity are inextricably linked. At the same time, economic studies might produce a wide range of opinions on this link.
At one extreme, it has been suggested that observed correlations between asset values and consumption are primarily driven by asset prices’ role as a leading indication of future economic activity (for example, Poterba and Samwick, 1995). This viewpoint indicates that current asset values reflect future economic growth projections, which explains the association with current consumption expenditure.
On the other hand, some argue that the observed association is merely due to wealth effects, in which wealth is permanent income that promotes spending.
Nobel winner Franco Modigliani’s seminal work can be credited with the establishment of the so-called wealth effect on consumption (1971). He claims that a $1 rise in wealth results in a five-cent increase in consumer spending.
Since then, this phenomena has become increasingly prominent in economic research and policy discussions. According to one study, both financial and housing wealth have a positive and significant effect on aggregate spending in the United Kingdom (Barrell et al, 2015). The marginal propensities to consume (MPC) out of total, financial, and housing wealth are 0.03, 0.02, and 0.03, respectively, according to the study.
However, this viewpoint has since been refuted. According to one study, variations in aggregate consumer spending account for only a small portion (less than 5%) of the fluctuation in household net worth (Lettau and Ludvigson, 2004). The findings reveal that the majority of quarterly asset value swings are due to transitory dynamics with little or no relationship to consumption, whether in the present or in the future.
The crucial point here is that consumption reacts to transient wealth changes differently than it does to permanent wealth changes. Although we can expect a 5% change in aggregate household consumption for a permanent $1 change in asset worth, the authors demonstrate that most wealth swings are transient and unrelated to consumer expenditure.
Similarly, a later study (Altissimo et al, 2005) claims that whether asset price changes are permanent or temporary influences whether they are transmitted to consumption expenditure. The research implies that temporary fluctuations in consumption have a lower impact on consumption, which is linked to the predictability of equity market returns.
Some suggest that even in a liberalized financial system, a major impact of housing wealth on consumption is improbable, owing to the possibility that both are influenced by other factors, most notably income expectations. Furthermore, because housing serves as a store of money as well as a provider of housing services, it will have an impact on nominal but not necessarily real consumption (Davey, 2001).
The study’s findings also imply that housing wealth is becoming less important than financial wealth in the UK (falling from 60 percent of total wealth in 1970s to about 40 percent in the early 2000s). Other research, however, reveal a strong influence of home wealth on household consumption in the United States (for example, Case et al, 2005) and the United Kingdom (for example, Barrell et al, 2015). (see MPCs above).
How reliable is the evidence?
The research listed above is mostly published in high-quality international peer-reviewed journals or working papers by specialists in the subject. They are based on evidence and are largely in line with economic theory. Furthermore, the cross-country empirical research stated demonstrate a certain level of resilience in the results.
What else do we need to know?
A lot of asset pricing research focuses on the relationship between asset prices and consumption, ignoring how consumption is influenced by investment and output. This method has been widely criticized, with research arguing that asset pricing should place a greater emphasis on enterprises’ investment decisions (for example, Cochrane, 1991 and Cochrane, 1996).
Others contend that while the existence of wealth impacts on consumption is well accepted, proof of the influence on investment is scarce (Davis, 2010). There’s also a debate about whether different consequences should apply to various countries and assets.
The lack of research data on investment has been attributed in part to historical flaws in the results for Tobin’s Q, user cost, and the financial accelerator. These variables have been shown to be incorrectly signed (for example, Oliner et al, 1995) or statistically unimportant in research (for example, Robertson and Wright, 2002). In fact, one study found that Q has a larger link with other variables like bond yields and debt and stock return growth than it does with investment itself (Lettau and Ludvigson, 2002).
Others, however, claim that rising stock prices boost output by boosting the net worth of potential borrowers, as well as the wealth and Tobin’s Q effects. Borrowers become wealthier, and external finance’s estimated deadweight losses decrease, resulting in increased investment and output (Bernanke and Gertler, 2001).
Furthermore, in G7 countries, there is strong evidence of large effects from asset prices via the financial accelerator, credit channel, and Tobin’s Q, as well as uncertainty (proxied by asset price volatility) in smaller OECD countries (Davis, 2011). Price and Schleicher (2007), Assarsson et al (2004), and Davis and Stone (2007), for example, all suggest that uncertainty and balance sheet effects on investment exist (2004).
The global financial crisis of 2008/09 has taught (or reminded) us, if nothing else, that the real and financial sectors of the economy are closely connected. As a result, research linking asset prices to financial difficulties is also worth highlighting. Deviations in credit and asset prices from historical trends were useful markers of future banking downturns, according to one crucial piece of research (Borio and Lowe, 2002).
Finally, it’s interesting investigating if consumption reactions differ depending on the source of the share price shock. There isn’t a lot of evidence to back this up.
Where can I find out more?
Asset prices and their relationship to the economy have a large corpus of economic study, which can be found in most economics and finance journals. However, in light of the current situation, a number of studies have been published:
The influence of the Coronavirus on stock prices and growth expectations: The term structure of investors’ expectations regarding economic growth is quantified in this study using aggregate equities market and dividend futures.
In real time, aggregate and firm-level stock returns during pandemics: This research indicates that daily aggregate and firm-level stock returns react to unanticipated daily changes in the coronavirus’s trajectory.
Stock market euphoria in response to Covid-19: This study uses stock market data to show how the health crisis became an economic catastrophe that was escalated through financial channels.
An explanation of aggregate stock market activity based on consumption: This research suggests that finance can discover basic risk characteristics that explain time-series behavior and aggregate stock returns, and that habit development is a key component in developing macroeconomic models that capture both asset price and quantity dynamics.
Consumption and portfolio choice over the life cycle: This research solves a ‘lifecycle’ model of consumption and portfolio choice with non-tradable labor income and borrowing limits, finding that disregarding labor income results in high utility costs.
The wealth and savings of UK families on the eve of the crisis: Thomas Crossley examines household wealth and savings using the British Household Panel Survey and the Expenditure and Food Survey, respectively. The research suggests that the majority of wealth is held in illiquid form.
Distribution, composition, and trends in household wealth in the United Kingdom 200612: The Wealth Assets Survey is used in this study to describe some key elements of the distribution of household wealth in the United Kingdom from 2006 to 2012. One important conclusion is that total wealth increased in real terms for working-age households but decreased for retirees.
What investments do well in the face of inflation?
- In the past, tangible assets such as real estate and commodities were seen to be inflation hedges.
- Certain sector stocks, inflation-indexed bonds, and securitized debt are examples of specialty securities that can keep a portfolio’s buying power.
- Direct and indirect investments in inflation-sensitive investments are available in a variety of ways.
Is cash a smart investment amid inflation?
According to Arnott, cash is frequently neglected as an inflation buffer. “While cash isn’t a growth asset, it will typically stay up with inflation in nominal terms if inflation is accompanied by rising short-term interest rates,” she continues.
Is financial stock inflation beneficial?
Consumers, stocks, and the economy may all suffer as a result of rising inflation. When inflation is high, value stocks perform better, and when inflation is low, growth stocks perform better. When inflation is high, stocks become more volatile.