"Is the Pandemic Hiding Future Inflation," UCLA Economic Letter, January 2021

How Asset Price Inflation Will Lead to Consumer Price Inflation

Highlights

The cover story of the December 12-18^th edition of The Economist was headlined, “Will Inflation Return?” The article discussed the recent history of why consumer price inflation, running at a low year-over-year rate of 1.2% as of November, has been so quiescent. However, there is another type of inflation that has been soaring. I am speaking of asset price inflation which is showing up practically everywhere.

Distinguished from ordinary goods and services, asset price inflation affects financial instruments such as bonds, shares, and their derivatives, as well as real estate and other capital goods. For example, after swooning in March, stock prices have soared with the S&P 500 up 16.4% in 2020 and the tech-heavy NASDAQ Composite up a startling 43.6%% (Figure 1). Further, home prices rose at the highest rate in six years with the Case-Shiller National Home Price Index up 8.4% year-over-year in October (Figure 2). And to top it off, Bitcoin, the crypto currency, ended the year up an astounding 306%.

The rocket fuel for the burst in asset prices is the Federal Reserve. Money growth as measured by M2 (including cash, checking deposits, savings accounts, time deposits, money market mutual funds etc.), has been running at 25% year-over-year rate, a record high. For now, money has been flowing into asset prices. At some point via the wealth effect, it could very well flow into consumer prices as consumers increase consumption by reducing their current savings and increasing their borrowing. 

Supporting this view is the fact that, as in the late 1990s, the public is once again actively participating in the stock market. Indeed, there is some evidence that the financial markets suspect an inflationary process is now underway.  The 10-year inflation breakeven yield – a measure of inflationary expectations embedded in the 10-year Treasury bond – has risen from 0.75% in March to 1.99% at year-end (Figure 3).

 I am cautioned that all of those who forecast an increase in inflation over the past decade – and I was one of them for a time – turned out to be wrong. Nevertheless, all of the ingredients are now in place for an acceleration in consumer price inflation. And remember: Unlike the 2010-15 period when banks were unwilling to lend because of regulatory constraints, those constraints are no longer there. Thus, inflation noticeably over 2% a year is far more likely than inflation below 2%.

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