Consumer prices – not asset prices

Earlier I mentioned a piece by Steven Gjerstand and Vernon Smith that was a bit harsh on monetarism – as it ignored that the monetarist explanation and a economic readjustment explanation could be complements instead of substitutes.

Now Barry Ritholtz points out another interesting point from the piece – their discussion of the fact that house price growth was effectively taken out of the CPI.  The money quote is:

If home-ownership costs were included in the CPI, inflation would have been 6.2% instead of 3.3%. With nominal interest rates around 6% and inflation around 6%, the real interest rate was near zero, so household borrowing took off.

Let’s discuss.

As an economist I get told all the time that the CPI understates “inflation” as it doesn’t include house prices.  My answer is always the same – CPI isn’t a measure of inflation, it is a measure of the growth in consumer prices.  Now housing is partially an asset and partially a consumption good.  The CPI includes a “rental-equivalent” value to take account of the consumption good – while the asset part is left out.  This makes sense for what the index is intended to measure – namely growth in consumer prices.

Inflation on the other hand is a peverse increase in the general price level of the economy – not an increase in the price of an asset, or a food type, but a consistent increase for no real reason other than it just does.  Given the rigidity involved with changing SOME prices, and given the cost of changing prices, this process is costly – and we would like to have an economy where we can pull this sort of process out.

In the long-term inflation has nothing to do with rising consumer or housing prices persee – inflation stems solely from permanent increases in the money stock.  However, in the shorter term, inflation is a wilder beast – and given that we care about it over this time horizon (as it influences planing and purchasing decisions) it is something we need to understand and battle.

Now, over the “medium-term” the primary driver of inflation is inflation expectations – as the “velocity of money” doesn’t have to be constant, so if society expects inflation it can make it happen, even if the money stock is fixed. (My views on inflation and price indicies can be found in more detail on this set of posts)

In this case we could ask – what were inflation expectations like in the US.

Source St Louis Fed

As we can see, inflation expectations weren’t as high as the “inflation” that was complained about in the article.  As a result, I do not believe that underlying inflation (which is near on impossible to measure 🙂 ) was that high either.  Fundamentally, people were making decision based on a belief that inflation was close to where the Fed believed it was – not where an index including house prices would say it is.

Taking this we have to ask – what the hell does rising asset prices have to do with anything.  The answer is a lot – but not by “being inflation”.

Asset price rises and wealth expectations

The rising house prices were a concern as household’s confused them for real wealth – and spent accordingly.  As a result, household’s consumed at an unsustainable level.  Now that they have realised that they want to, and need to, pull back.

This is similar to the “real interest rate argument” that was made – however, it makes the channel through which the problem occured more transperant.  Framing it this way implies that the crisis may not have been the result of “interest rates being too low” – it may have instead been that there was some simple issue with the way people were forming expectations.  I blame FOX news 😉

Here the underlying issue is not one of “inflation” and its damaging consequences to relative prices in the economy.  The underlying issue is “households expectations” – which fell wildly out of whack with reality.  In such an environment, the US and NZ both invested heavily in consumption infrastructure, while China invested in production infrastructure.

The shock of falling house prices has seen consumption slump in the highly indebted countries, causing some of this infrastructure to become both sunk and worthless.  In this case, the world economy must go through a costly readjustment – and policy cannot help directly.

As mentioned before though, the idea that keeping inflation expectations (and to some degree consumer price growth and other price growth) positive is essential.  By doing say, we lower the real interest rate – helping to ease the transition path of the readjustment (although we must be careful not to screw up the relative price signals associated with the change in economic structure).

But more importantly IMO – we help to reduce real wages.  In the labour market, the demand for labour internationally has just taken a hit.  Given that it is difficult for nominal wages to fall, getting real wages down (through inflation) is key in order to prevent even sharper increases in unemployment.  Ultimately, if real wages don’t fall, more people get laid off – that is the way it is.  The more people that get laid off, the more production and therefore income falls, which implies more pain for society. (Discussion here)

Conclusion

The asset price increase from housing SHOULD NOT be counted as inflation.  However, the fact that it happened IS important for policy and forecasting.

The seperation of “inflation” and “asset price increases” is very important for diagnosing what the problem is – and how policy might be able to help improve outcomes.  As a result, let us all try to keep this difference separate – so that we can truly figure out what needs to be done, what pain we are stuck with, and if there are any institutions that need changing to improve outcomes in the future.

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  • mrg

    So does that mean you shouldn’t count CPI as part of the house price deflation as well? I’ve always had a problem with that as in my mind, without wage inflation, CPI is making houses MORE unaffordable, not less.

  • John

    “As we can see, inflation expectations weren’t as high as the “inflation” that was complained about in the article.  As a result, I do not believe that underlying inflation (which is near on impossible to measure ) was that high either.  Fundamentally, people were making decision based on a belief that inflation was close to where the Fed believed it was – not where an index including house prices would say it is.”

    But when asked about inflation expectations, are people only responding to consumer goods and services and ignoring real estate?
    As in:

    “The rising house prices were a concern as household’s confused them for real wealth – and spent accordingly.  As a result, household’s consumed at an unsustainable level.  Now that they have realised that they want to, and need to, pull back.”

  • “So does that mean you shouldn’t count CPI as part of the house price deflation as well? I’ve always had a problem with that as in my mind, without wage inflation, CPI is making houses MORE unaffordable, not less.”

    CPI is still useful for giving us an idea of the relative price of an asset – as the ultimate goal of the asset it to create a stream of revenue for consumption.

  • “But when asked about inflation expectations, are people only responding to consumer goods and services and ignoring real estate?”

    Indeed – inflation expectations themselves are a pretty biased measure as well. It isn’t clear exactly what prices each individual is thinking about when answering the question.

    That is why I prefer to look at the trend in quality adjusted wage growth – as this gives us some idea of what pay rise firms and employees are willing to give independent of productivity. Over time this pay increase will be real inflation expectations.

    However, I don’t know where that cheeky data sits in the US – as people always say real wage growth has been weak my suspicion is that it would have run along with measured inflation (or possibly even weaker …)

  • Great information, I will be linking back to you and going to look around at your other posts.