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Thursday, April 8, 2021

Asset Prices And Inflation

One of the more heated debates around inflation is whether asset prices should be included within the concept. House prices are the main area of concern, since one of usual characteristics of middle-class lifestyle within the developed world is home ownership. Financial asset prices – mainly stock prices – also pop up in the conversation.

(Note: This is an unedited draft of an introductory chapter from a manuscript about inflation. Not giving detailed analysis, rather explains why I am interested in the relation between asset prices and inflation.)

My view follows the conventional economic opinion: asset prices are in a different category than the prices of consumer goods for current consumption, and since they behave quite differently, it does not make sense to lump them together. The Consumer Price Index in the United States no longer includes house prices, which is standard for developed countries now. This reflects a desire to have the CPI reflect the cost of current production. Meanwhile, I typically use “inflation” as a shorthand for consumer price inflation, following the convention generally held by market commentators and economists.

I see two main reasons for objecting to this view: the cost of living ought to incorporate house prices, and arguments that “inflationary policies” are seeping into asset prices.

Finally, there is a belief that house prices were removed from the CPI as a tactic to purposefully reduce the rate of measured inflation. I will return to this topic later, when I dig deeper into the discussion of house prices.

Cost of Living

Given the importance of homeownership to the middle-class world view, one can see that it might be perceived as a necessity. (Shelter is a necessity, and renting shelter is an option – and rent is included in the CPI.) Therefore, one could argue that the cost of buying a home ought to be included in the cost of living. And if one assumes that the CPI reflects the cost of living (ignoring what the economists and statistical agencies have to say), one ends up at the position that house prices ought to be in the CPI. 

Most of this chapter will revolve around discussing housing. I will summarise my arguments in the following way: even if we want to consider a home purchase as part of the cost of living, we need to reflect the reality of how homes are purchased: with very considerable amounts of debt. Interest rates have collapsed since the early 1980s, and house prices have risen in consequence.

As for financial asset prices, linking them to the cost of living does not make too much sense (other than for someone setting up a trust fund).

Inflationary Policies Have Driven Asset Price Inflation!

Another common argument runs along the following lines: central banks have conducted inflationary policies (e.g., “printing money!”). What is happening is that the money allegedly goes to some shadowy group the speaker has an ideological complaint against, and they bid up asset prices first. Then, the “inflation” will seep into the prices of other goods, and thus eventually show up in the CPI.

This does match one old theory about the inflation process, which is popular among internet Austrians. I will discuss it in more detail in Section TK. The immediate problem with this theory is that it does not match the observed data: we have had a generational bull market in almost every asset since 1980 (with a few bear markets mixed in), yet inflation rates fell and were then quiescent since in the 1990s.

I am also somewhat cynical about this theory and its proponents. Many of the people making these arguments forecast inflation because of central bank policies – and were horribly wrong. In desperation, they seized on anything that rose in price, and want to pretend that this vindicates their forecast.

The reality is that there is a large sub-culture of people who sell books, newsletters, and curios, all premised on protecting buyers of their wares from the evils of inflation of fiat currency. As a writer, I know very well I could probably sell way more books if I waxed lyrically about the coming demise of the major currencies in a bout of hyperinflation. (Admittedly, I might be doing so under a pseudonym.) Since the general public is not that greatly perturbed by the roughly 2% inflation that has prevailed since the early 1990s, they need some kind of hook to excite readers.

(c) Brian Romanchuk 2021

35 comments:

  1. Glad you're spending some time on this topic. I agree: housing is the asset which matters most. Renting simply isn't a realistic option in many (most?) market so home prices need to be in CPI. I also agree that we need to consider how homes are financed but that gets tricky obviously (e.g., adjustable rate mortgages).

    You have an interesting real-time test case to work with now in the US as home prices are rising quickly but "housing costs" are falling according to official measures.

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    1. It’ll take a few posts to get to the question “should house prices be in the CPI?,” and I agree with the consensus - they should not be. Since I will be writing this out shortly in my usual methodical (plodding) fashion, I’m not going to attempt to summarise my logic here.

      One key point: very few first time home buyers plop down 100% down payments on their house. Instead, they have a mortgage. Interest rates are not constant (as if they were, I’d have to find some other domain to write about).

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    2. I can definitely understand why raw house prices wouldn't make sense. But there must be some solution better than what we have now which shows, for example, a housing cost crash amidst a home-price boom.

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    3. It’s rent based. They are rising slightly less quickly than they were.

      30-year mortgage rates are at record lows. Why wouldn’t house prices be at record highs?

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    4. Prices also move up as we move into a financialized, rentier economy.
      People who work for a living and are just getting by speak to people at parties with nice cars and worse jobs. How did they get it? Flipping houses. Some of the former wealth creators move into house flipping, more credit is created, less real goods are created. Living standards drop.

      We now live in a world where rentiers take the spoils.

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    5. Brian, lower interest coast do not justify enormous appreciation especially in relatively short time especially in some markets where increases have been nothing short of grotesque.
      Many MMT proponents actually argue that low interest rates are deflationary (a deflationary effect that should/could also involve asset prices)

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    6. Feels like the market is led to low rates by a lack of real growth, which then makes rentier activity more and more viable as it's not taxed fairly, which then leads to even lower growth, etc.
      Surely low rates are *a response to* a lack of opportunity to invest in ventures with a high rate of return.

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    7. Mortgage rates are at a small premium to the risk-free curve, with wide variations in structure across markets. Risk-free curves are heavily determined by our New Keynesian central banker friends, who would be happy to drive the curve negative if it would not mess up everything.

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  2. Brian I buy your books and follow your blog but here I have to disagree with you, you are wearing your ivory Tower hat a bit too much here (allow me the expression).
    It does not matter how I buy a house, in cash or with mortgages, housing prices are out of control in many part of the country (I live in the US) and they should be part of the cost of living calculation. Do not get me started on medical expenses.
    We can argue about the CPI composition and whatnot, personally I include everything in what I consider inflation, asset prices should be definitely be there.
    While I consider Shadowstats and the others crankery, on the other side we should try not to lose touch with real life here.
    I'm glad the Central Bank of New Zealand finally acknowledging the runaway housing prices in their policy decisions (hopefully it's not just empty rhetorics)
    Some people are literally leaving Seattle because of rising cost of living, please do not reply with vague "lifestyle choices" comments.

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    1. You can put whatever you want into your personal cost of living. Statisticians cannot calculate a cost of living metric that makes sense at a national level. The CPI is not a cost of living index.

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    2. Brian, all I'm saying is that we should do a far better work in calculating real inflation for real people.

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    3. As I said in response to another comment, you are responding to what you think my book says, while in reality the book is not written. CPI is calculated the way it is for good reasons, and it meets particular needs. You want it to do something else. Well, you need a different tool for a different job.

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  3. Also, "shrinkflation" is very real.

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    1. I think there is also a generational perspective to this. Older generations who have housing are just not able to imagine the huge toll gate for younger people.

      In addition to shrinkflation the quality of most goods has dropped massively. Many clothing items such as shoes are now almost a subscription service. Trainers fall to bits in no time. Jeans wear. Monthly bills are no longer just groceries plus a few incidentals.

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    2. Ben, my house has literally more than doubled in value in 8 years (Seattle housing market was not even hit that hard during the 2008 crisis to begin with and we were in full recovery already when we bought it), we did not do any meaningful improvement, my neighborhood is not any more desirable than before nor a dollar has been spent for infrastructure.
      Seattle level of attractiveness for high tech job is still more or less the same and actually we lost a bridge (the main artery connecting to downtown) that, hopefully, will be repaired in 2022, commuting currently is a nightmare. Our income did not go up anywhere near the same clip (not even a fraction) and we work in in demand fields (IT and finance).

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    3. To be clear: your land has doubled in price.

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    4. “Shrinkflation” is purely a device aimed at consumers. National statistical agencies are not idiots, they control for product changes. The CPI is rising at about 2% per year in most developed countries (ex-Japan). However, consumers dislike nominal price changes, so manufacturers play around with sizing.

      I was a bit young to pick up on that in the 1970s, but I don’t think anyone would bother with that: they just raised prices. That’s what a real inflationary environment is like.

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    5. Brian "National statistical agencies are not idiots, they control for product changes"

      Not calling them idiots but is not as simple as it seems....from the Australian bureau of Statistics

      https://www.abs.gov.au/articles/quality-change-australian-cpi

      You also have to take in consideration quality changes which are much more difficult to capture.

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    6. I’m aware of the difficulty of quality adjustment. I’m turning into a grumpy old man, but quality drops are in very specific items. I don’t see it as an across-the-board problem.

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  4. There is a lot to agree with here. I understand why you are focusing on the cost of carry, per month. However I think what this hides is the long term drag on disposable income.

    We used to measure mortgage payments by primary income. For 25 years. Now we have "household" income (two adults working), and for longer terms.

    This is economic activity that can't go on consumption for those most likely to spend it.

    Inflation fails to capture this as it's all about the month to month cost, not the reality - the total cost. And in my humble opinion, that does matter.

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    1. Cost of carry does not matter...eventually you have to pay the increased price, period...it works if you have an asset base (owning a house already) so you can play the appreciation game but what about new entrants??
      As you said, this is economic activity re-directed somewhere else...also a final note about reduction in cost for building a house...What about quality?? Have anybody noticed the shoddy quality of some modern construction?? Literally, few notches above cardboard homes.

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    2. I agree the underlying price matters. My point was to Brian that inflation only covers the monthly cost, but the drag is far greater.

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    3. You are jumping to incorrect conclusions about the contents of my chapter before I have even written it. The cost of homeownership is complex, but once you’ve locked in the mortgage, it does not change - for 30 years in a US conventional mortgage. (Canada rates reset in practice after 5.)

      As for the two income bit, that’s just telling us that households spend a greater percentage of their income on housing. That’s exactly what one would expect if real incomes are rising. I will be discussing this.

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    4. Brian you keep mentioning the interest rate, I look at the price of the property. Cost of homeownership is not complex.

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    5. I look fwd to reading it when published!

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    6. Lower the interest rate, and the exact same monthly payment gets you a larger principal value. The only part that scales linearly is the down payment, which is typically 20% for first time buyers. (And less than that in Canada, courtesy of the CMHC.)

      For people who already own homes, they are only exposed to the differential of house prices.

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  5. @Ben, Domenic, Anonymous:
    Brian is discussing the components of the Consumer Price Index not the implications of asset price increases, including house prices.
    Carry costs matter most for many, probably most, people: $4200 monthly gets you a mortgage of $1,00,000, at 2%, but only $730,000 at 5%. Same monthly payment over 25 years and your house is paid off. So house prices get bid up higher due to low interest rates (as Brian notes). Not enough has been done to restrict credit and various speculators to offset the effects of low interest rates. Michael Hudson has written about how this serves the interests of the banking and real estate sectors.

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    1. I definitely agree with Hudson that some sort of lending guidance has to be implemented somehow. Again, in many markets the price increases have been spectacular. Lower interest rates and looser lending standard can definitely do the trick.

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    2. In principle I would not even consider a house an asset, at least a primary residence. It does not produce any income and it actually cost money to maintain.

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    3. Sure all that around cost of carry is very basic. The problem is buyers are being asked to make ever larger bets that rates will stay low for the loan duration. Also background inflation erodes the debt when rates are "reasonable". 4k/month at 7% with wage inflation of 5% will see your payments become trivial after 10 years. 4k/month at 1% with no wage inflation means you are at the limit for the duration. In addition if rates do move up at any point during that time you are squeezed very hard.

      So it's not symmetric. The other problem has been a cultural shift as rates have been walked down, each time to bail out rentiers. People see land speculators doing far, far better than their "real" jobs. So they become speculators. Demand goes up, prices go up. It blows up. Rates get cut. Anyone who sat out the last round throws the towel in and becomes a speculator. Pretty soon everyone is working in the FIRE sector and one guy is doing all the farming.

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    4. What country are you referring to? In the US, conventional mortgage rates are locked for 30 years. Other countries face greater rate uncertainty. However, most of my readers are in the US...

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  6. "One of the more heated debates around inflation is whether asset prices should be included within the concept."

    I think you mean ".....within the concept of CPI ."

    Surely you are not trying to say that asset price increases cannot be subject to 'inflation'.

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    1. No. I will have a section on this in the beginning of the book. The generic “inflation” can refer to the generic “price level,” but within market/economic commentary it’s usually a shorthand for consumer price inflation, of which CPI is a standard measure.

      It refers to the price of current production. Asset prices are normally not included in either measure.

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  7. what do you think Canada should do to counteract the growing housing bubble?

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    1. They should not have loosened CMHC lending standards to the extent that they did. Tightening them up should be a long-term goal. However, they can’t really afford to blow up the economy until there’s a good recovery going throughout the economy.

      Raising interest rates would cool housing, but the financial markets would freak out. The Canadian dollar would likely be bid up, which hurts exports, and is not going to help rebalancing the economy away from a dependence upon housing.

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