Wednesday, July 17, 2013

"Asset price inflation" is not inflation



Situation 1: Imagine there is a new craze for meatloaf. It's a fad. Meatloaf restaurants pop up all over America, from Park Avenue to Lubbock, Texas. As a result of this increased demand, the price of beef goes up.

Situation 2: Imagine everyone in the country magically agrees to change the definition of "one dollar" to be what used to be called "fifty cents". The price of everything would immediately gets multiplied by two. That includes beef.

The first of these situations reflects an increase in the degree to which people are willing to give up other useful stuff - back massages, cars, etc. - for beef. The second does not. Hence, we would like to differentiate between those two situations. Traditionally, economists do this by calculating a "price index", which is an average price level of all the useful stuff that people buy. In the first case, the price index will go up only a little, or maybe even not at all, as a result of the increase in desire for beef that led to beef's price rise. This, economists call a "relative price change". But in the second case, the price index goes up a lot as a result of the change in the unit of account. This, economists call "inflation".

There are some subtle points here, concerning what would ultimately happen as a result of these two situations, and how we would measure these changes if we were gathering data. But you get the basic point. Prices can change because of changes in the value of one thing relative to another, or they can change because of changes in the unit of account. We want to distinguish between these things. And "inflation" is the word we have chosen to refer to the latter kind of change, not to the former.

This is why I don't like the term "asset price inflation". This is a term that some people use to refer to increases in asset prices. They use the word "inflation" for two reasons:

1. They think that asset prices change in response to monetary policy. The price index is also widely believed to change in response to monetary policy. Hence, they see an analogy.

2. They think that asset prices, such as the price of used houses, should be included in the Consumer Price Index (currently only "housing services", not house prices themselves, are included in the CPI).

I could argue with either or both of these. But I am not going to. Because the reason I dislike the term "asset price inflation" has nothing to do with either of these points.

Suppose we did include house prices directly in the CPI. They would still be only a small part of the CPI. Suppose house prices were 10% - a hefty chunk - of the "market basket" that is used to calculate the CPI. And suppose house prices went up by 10% while the rest of the price index remained unchanged. That would increase inflation by only 1 percentage point.

Most of the increase in house prices (9/10 of the increase) would not represent inflation. It would represent a rise in the relative price of houses. It would mean that people are willing to (implicitly) give up a larger quantity of back rubs, iPads, cars, and meatloaf in order to obtain a house. It would not indicate a change in the unit of account. The unit of account would remain relatively constant, changing by only one percent, even as house prices rose very substantially.

So to point to an increase in the price of houses and to call that "asset price inflation" is just as misleading as it would be to point to an increase in beef prices and call that "beef inflation". There's only one kind of inflation, and that is inflation itself. You have to add everything in before you can tell me how much inflation there is.

Now at this point you may be thinking, "OK, I see your point, but so what? House prices are important, so central banks should pay attention to relative changes in house prices. So this is all just semantics. Call it inflation or call it whatever, rising house prices still means the Fed needs to tighten."

But here's the thing: We know inflation - the real inflation, i.e. changes in the price index - is bad if it goes too high or too low. We know that, whether the ideal rate of inflation is 1% or 6%, it almost certainly isn't 15% or -4%. Within certain bounds, price stability is good. With asset prices, we have no such guide. If houses go up in value by 15% in a year, are we sure we want to push them back down? Our recent experience with a housing bubble probably convinced a lot of people that the answer is "yes", but remember that housing price rises don't always indicate a bubble. And on the flip side, suppose house prices went down by 4% in a year. Would we want the Fed to always push that back up?

What I'm saying is: Even if the Fed really ought to respond to asset prices, the way in which is should respond is not very similar to the way in which it should respond to inflation.

So even the loose, casual analogy between inflation and asset price changes is flawed. They aren't even similar phenomena. They don't generally have similar impacts on the real economy. And they don't demand similar responses from the Fed. So let's stop using the misleading term "asset price inflation"! Let us strike it from our lexicons!!

82 comments:

  1. Well, I agree with you. But don't economists and Fed analysts contribute to this problem by using the CPI and other such indices as their measure of inflation? After all, if the CPI goes up, but nominal wages stay flat, then all we have is a relative price change - a change in the amounts of goods people can purchase with an hour of labor - and not a true inflation in the proper economic sense.

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    1. So a change in CPI is not inflation?

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    2. No, I would say the opposite. If what they really want to do is hit an inflation target (leaving aside the question about whether the theory behind the macroeconomic role of inflation and inflation targeting makes sense), then they should use an index that builds in wages in some way.

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    4. Pardon my ignorance, but isn't the case you describe in your initial post "real" inflation? Assuming that the price index is a representative sample of the overall price level, that wages are constant with respect to time, and that the price index increases with respect to time, then there has been a fall in real wages.

      This sounds like the *bad* inflation Noah referred to, no?

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    5. That's a decline in the standard of living, and it definitely would be bad for most of us. But my understanding is that that is not what economists mean, in strict propriety, when they talk about "inflation".

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    6. Just to elaborate, economists often say that one potential benefit of inflation is that it reduces the real value of debt for debtors. But if nominal wages stay fixed while other prices rise, then the debtor's debt is no less burdensome than before. They still have to work the same number of hours to pay off the same fraction of their outstanding debt.

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    7. Actually I do not agree. For instance how would he name general rise in prices caused by supply side shock? What if that shock was concentrated only on some goods - like oil supply shock or bad weather decimating corn production? So prices didn't change but nominal (and real) incomes fell.

      And alternatively, what if average prices did not change a millimeter because money printing was to the last cent offset by better technology? So yeah, change in medium of account caused prices of widgets to rise but new technology made price of gadgets to fall to offset this with overall average price level not changing at all. It was all about relative price change between gadgets and widgets. So prices didn't change but nominal/real incomes were increased

      Inflation simply has too many definitions and not, that it is measured by CPI or GDP deflator does not matter. I remember that Scott Sumner hates inflation exactly for this reason - that it is impossible to find out what somebody means if he says this word - and this goes beyond thinks like "asset price inflation" or "deflation in IT sector".

      People should start using Real/Nominal incomes instead.

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    8. According to Investopedia, Inflation is satisfied when the overall price level increases, resulting in a fall of purchasing power. This is exactly the case I outlined and consistent (I believe) with Noah's understanding, because the unit of account changes in above case.

      What I am wondering is whether above case is necessary or sufficient for Inflation.

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    9. Jefftopia: What does it mean that "unit of account changes"? What if there has been an oil supply shock and today we produce and consume less than before because energy is more costly in real terms. This is textbook example of "relative price change story" - oil gets more expansive compared to other things. Price level may increase despite no changes in "unit of account" (no new dollars printed etc.).

      Another example: what if tomorrow lots of people will prefer to eat organic food? Organic food requires more real resources meaning the price of food will increase. In practice this will have similar impact as the oil shock example, it is almost as if we were stricken with negative technology shock. Prices will rise, but people think that it is worth it because perceived quality also increased.

      Inflation is not a simple concept. To pretend that the only problem with it is things like "asset inflation" and that it is clear otherwise is simply not correct.

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    10. No, this isn't correct. A price increase for a commodity is treated the same way as a price increase for an asset; it is *not* inflation unless the commodity price increase results in an increase in the price of all other goods! Otherwise, as you stated, it is nothing more than a relative price increase. If, however, the increase in commodity price results in an overall increase in the price level, then purchasing power declines and the unit of account therefor _has_ changed, assuming income is constant.

      That isn't to say we should ignore commodity price increases, in fact it is part of CPI and PCE (I believe), but Noah outlines how to treat this case.

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    11. What does this sentecne mean: "A price increase for a commodity is treated the same way as a price increase for an asset; it is *not* inflation unless the commodity price increase results in an increase in the price of all other goods!"

      So if increase in price of a commodity *causes* all other prices to increase except for 1 other commodity it is not inflation? I can assure you that this is not how many economist define "inflation" which kind of proves my point.

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    12. Nathanael10:18 PM

      Good point, Dan, and one I just made myself.

      If wages stay flat or drop, and CPI goes up, there is no inflation. There is a drop in the standard of living. (Thanks for putting the correct name on the phenomenon.)

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  2. The only way to measure the change in the unit of account is to measure the relative change of the price of a basket of goods. So all inflation is is relative price changes in an economy. All "real" means in economics is "relative" anyway.

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    1. Isn't the ideal somehow to distinguish the monetary phenomenon of inflation from changes in the relative market values of goods that would obtain even if people bartered rather than using money? Changes in the price of apples in terms of bananas, or the price of bananas in terms of an hour of labor, are not themselves monetary phenomena and have no direct connection with monetary policy. Changes in the dollar price of everything - apples, bananas and hours of labor included - are a monetary phenomenon, and should in principle be susceptible to the influence of the monetary authority and monetary policy.

      I know that in a monetary economy, these phenomena are related in various ways because of short-term non-neutrality at least, and because high inflation creates more opportunity for more rapid non-sticky adjustments in relative prices. But still the people who claim to be targeting an inflation rate and not a relative price adjustment should be measuring the right thing.

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    2. John S9:22 PM

      Isn't the ideal somehow to distinguish the monetary phenomenon of inflation from changes in the relative market values of goods that would obtain even if people bartered rather than using money?

      Dan, you may be interested in these links. George Selgin has brought attention to the "productivity norm" (not his original idea; he traces it historically) which would allow increases in productivity to be reflected in gently falling prices ("benign deflation," such as we see in electronics and computers).

      Re: monetary policy, as David Beckworth elaborates, "This 'productivity norm' would have monetary authorities target a nominal income growth rate equal to the expected growth rate of real factor inputs. Such a nominal income target would allow the Fed to accommodate the real output effect of factor
      input growth, but not react to total factor productivity growth. The Fed, therefore, would allow the price level to inversely reflect both shocks to and anticipated changes in total factor productivity.

      Selgin contends that such a monetary rule would avoid the potential drawbacks of factor input-generated deflation, but still minimize nominal spending shocks and the output gap. The productivity norm, like other nominal income stabilizing rules, would also provide a natural offset against aggregate demand shocks and any malign deflation."

      More by Beckworth here: "Aggregate Supply-Driven Deflation
      and Its Implications for Macroeconomic Stability" http://www.cato.org/sites/cato.org/files/serials/files/cato-journal/2008/11/cj28n3-1.pdf

      Selgin's article: "MONETARY EQUILIBRIUM AND THE PRODUCTIVITY NORM OF PRICE-LEVEL POLICY" http://www.cato.org/sites/cato.org/files/serials/files/cato-journal/1990/5/cj10n1-14.pdf

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    3. "Isn't the ideal somehow to distinguish the monetary phenomenon of inflation from changes in the relative market values of goods that would obtain even if people bartered rather than using money?"

      There is no way to distinguish the between "monetary" inflation and changes in the relative prices of goods, because the price of money over time is defined as the change of relative prices of goods. Unless you are an Austrian and simply redefine inflation to mean increase in the money supply.

      I am sympathetic to Noah's point here about how "asset price inflation" is often misused, but I think that this post skirts over the ways that inflation is much more complicated and poorly understood than economists like to admit.

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  3. "This is a term that some people use to refer to increases in asset prices."

    You're being too charitable (as I'm sure you know). Many of those people use the term because they really, really, want there to be some "inflation" to justify tighter money, but there isn't any.

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    1. And many don't. I use the term because a) I suspect the primary effect of QE is increase asset prices (that is, QE causes inflation in an economy that is largely decoupled from the real economy as experienced by most people), and b) I'm ignorant.

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  4. Noah,

    "Suppose we did include house prices directly in the CPI."

    But we do!

    First, there is an important distinction between consumption and capital goods. The CPI is supposed to measure the price of the consumption basket. The question is, how do we include consumption derived real assets? The answer is that we need to add the convenience yield of capital assets, wherever consumption is otherwise not included directly. That means for houses we add in equivalent owners rent, a value implied from the house value. For commodities that are owned directly by consumers (e.g. gold) we could add the convenience yield (derived from the futures market if you want). There is an additional complication which is that all physical goods are capital assets, just more or less long lived. For sticky price time scales (a few years) it makes sense to treat houses as capital, and iPads as consumption.

    Second, in conventional sticky price macro, there is no reason to care about non-sticky prices like energy, food, commodities and liquid capital assets. Since house prices do not adjust easily (are not martingales), it's important to include equivalent owners rents in targeted price baskets. Gold prices, on the other hand, are not statistically
    distinguishable from efficient capital asset prices. So there is no reason why we would include the gold convenience yield in the social planner's utility function (i.e. central bank target). If the price can't be different from the most efficient value, why would a government body try to change it? So equivalent owners' rents are in, commodity convenience yields are out.

    So should the Fed every care about liquid asset prices? Not for
    stick-price reasons but there are other nominal rigidities than sticky prices. The main one is nominal debt. That makes house price doubly important because they are both sticky *and* the biggest source of consumer collateral. But if a perfectly liquid asset is used significantly as loan collateral (e.g. low haircut mortgage bond repos), that also creates possible nominal instabilities which are exactly the kind of things the Fed should be worried about.


    "Even if the Fed really ought to respond to asset prices, the way in which is should respond is not very similar to the way in which it should respond to inflation."


    From the perspective of sticky house prices, I think properly including implied owners' rents is a the correct and adequate solution. The real trouble is what to do about leverage. and whether controlling asset prices is a good way to prevent excessive borrowing against (ex post) over valued assets. I doubt it. Trying to dampen asset volatility, if successful, will increase fair value from a portfolio theory perspective, promote greater leverage and ultimately result in further upward price pressure. The only way to prevent systemic harm from debt fuelled asset prices is to insulate the money system from financial markets, e.g. via narrow (100% reserve) banking.

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    1. K wrote:

      "Gold prices, on the other hand, are not statistically
      distinguishable from efficient capital asset prices. So there is no reason why we would include the gold convenience yield in the social planner's utility function (i.e. central bank target). If the price can't be different from the most efficient value, why would a government body try to change it? So equivalent owners' rents are in, commodity convenience yields are out."

      But with inefficient cartel pricing in effect for energy, can't one assume a short run sticky pricing effect in commodities as well? The BLS attempts to work around this with their concept of "core rates of inflation" to detrend these effects in the short run.

      Further in trying to damped asset volatility, doesn't the Fed induce even larger breaks in the underlying asset markets because they no longer perform in a martingale function?

      I would point out the recent Fed untaper promise to calm markets that already have not had a serious correction since the crash. One could also argue that by deregulating housing finance, the entire financial system was destabilized, and houses become subject to much more volatility- which led to a serious financial solvency crisis.

      In short, only regulation, and effective regulation at that, can prevent excessive borrowing, and remove the heads Wall Street wins, tails you lose effect that Main Street has begun to ascribe to Wall Street in general. Corzine's betting fiasco in blowing up a commodities brokerage firm by taking hedge fund style prop bets is a great example of the destruction of regulation.

      Without the high returns from volatility, much of the speculative function of Wall Street would disappear, and the high returns generated from actual capital destruction would no longer be so easily captured.

      These changes are fought tooth and nail by the winners, with massive buckets of cash to influence the political system- ultimately to the detriment of the country.

      Massive gambling combined with exquisite rent seeking is the root cause of this, and it took 30 years to fully express.

      Someday this war's gonna end...

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    2. Nathanael10:15 PM

      "In short, only regulation, and effective regulation at that, can prevent excessive borrowing, and remove the heads Wall Street wins, tails you lose effect that Main Street has begun to ascribe to Wall Street in general. "

      Actually, there's a second way to prevent it.

      Confiscatory income tax after, say, the first $500,000 a year.
      Confiscatory estate tax after the first, say, $20 million dollars, as a backup in case someone works around the income tax.

      If winning your big speculative bets doesn't actually make you filthy rich -- if most of the money is simply taken away by the government on April 15 -- it reduces the incentives to do all that speculative stuff. This was tested in the 1950s and it WORKED.

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  5. 2 things not touched on in your post that bother my uneducated mind: (1) money is an abstract concept (i.e. is the $5000 available credit on a VISA card money, or just the $13.80 you just swiped the card to pay for food) and (2) inflation is an abstract of the first abstract (i.e. the general depreciation of the value of a fixed currency unit over a fixed time period) so all "inflation" measures are at best highly educated guesses. wouldn't this post be more appropiate on a semantics blog.

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    1. 1 thing bothers me about your post... (1) it's abstract, so it's at best an educated guess.

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  6. i guess the ultimate question is what is the rationale for including or not including something in the price index.
    why are stocks not included, or houses? they are all afeter all measured in the unit of account
    i a agree that to call a relative price change 'inflation' is wrong, but what are the considerations for including a good, service or asset in the price index?

    a related question: why do we call the spike in the price of oil that happened in the 70s 'inflation'? wasn't taht just a (very big) relative price change?

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  7. The concept of inflation (and how it's calculated) has always confused the hell out of me. Typically if enough people I trust tell me inflation is low that's good enough for me (with the understanding that 70s type runaway inflation is bad), but I couldn't show my work.

    I thought (I think) though that you really couldn't get sustained inflation without wage increases. So if the price of everything doubles but so do wages, isn't it all relative? Which brings me full circle.

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    1. when wages don't go up and everything else does, then you have subjective inflation which is just as bad as real inflation...
      The problem is wages are not going up, except for the rich...

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    2. Subjective inflation? Bah, hell if I know. And based on the other comments here, pretty much neither does anyone else. JFC Noah, DO something. ANYTHING.

      #OccupyNoahpinion

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    3. If the price of everything doubles, and your wage doubles, then everything is the same, right?

      Well, no. The loan you had is now half as big. Or the pile of savings that you had is now half as big.

      That's the effect of inflation. Asset price 'inflation' is a totally different effect, and not related to actual inflation.

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    4. Nathanael10:08 PM

      When wages don't go up, but everything else does, you have a SERIOUS problem. The problem is not "inflation". The problem is that employers are stealing money from their workers. The problem is what we might call a *Marxist* problem.

      theeuromillionsnet: you have pinpointed THE problem.

      It should not, however, be called "inflation", that's just confusing. It might be called "those goddamn thieving corporate executive bastards, we ougghta take their money away and send 'em to the guillotine". ;-) But if you've got a shorter name for it, I'd like to hear it...


      "when wages don't go up and everything else does, then you have subjective inflation which is just as bad as real inflation...
      The problem is wages are not going up, except for the rich..."

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  8. Ok Noah, then break the following cycle: Fed drops the interest rates, people start searching for better investments to put their savings on (search-for-yield) and start buying houses, signing mortgages and getting some nice securities to hedge the risk to the bank. So, due to lax monetary policy, price levels start to change. Since the central bank is borrowing money at such low rates, and with the ability of banks to raise the credit growth rate through M1 and M2, money supply will expand. So, a relative price change might give some clue about a forthcoming rise in inflation. I see a causal relationship there.

    If not, what am I missing?

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    1. very simple: the fed & policy cherry picks data in terms of what counts as inflation and what doesn't. Greenspan, for example, used the rapid rise in stock prices in the 90's to raise rates.

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  9. We have a two-track economy- what the government purports versus the public & private sectors. The former (CPI, treasury yields, interest rates, unemployment) is indicating deflationary forces, weak economic growth, and a possible liquidity trap and the later (private sector profits & earnings, export growth & consumer spending, stock market) contradicts this. We cannot use a conventional economic model to model the economy because none take into account this dichotomy. We have a simultaneously booming and sluggish economy.


    Inflation is everywhere- in not just asset classes like art, real estate and stocks, but non-discretionary goods. I can name a dozen things off the top of my head that are not only more expensive since 2008, but have exceeded rate of the CPI.

    These 'geniuses' that saved the economy apparently forgot to save main street, too. Now we have to pay the bill in higher living expenses and high unemployment so large caps & bank can horde more money and wall st. can continue gambling with bailout funds..

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    1. Nathanael10:11 PM

      "We cannot use a conventional economic model to model the economy because none take into account this dichotomy."

      Some very old-fashioned economics models explain this -- 18th, 19th, and early century models which pay attention to DISTRIBUTION. Distribution is the key.

      In fact, Marxist models are working better than "modern" models these days, and it's because "modern" models (designed by lackeys of the rich) ignore distribution (because they were paid to ignore it).

      Keynes's models are close enough to Marxist to work right, and without some of the stuff that Marx got grossly wrong. Veblen's models are a substantial improvement on Marx, as well.

      This is exactly right:
      "These 'geniuses' that saved the economy apparently forgot to save main street, too. Now we have to pay the bill in higher living expenses and high unemployment so large caps & bank can horde more money and wall st. can continue gambling with bailout funds.."

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  10. What the fed could have done regarding home prices from 2003-2007 was to use its power as a regulator to stomp on mortgage abuses, and problems in the MBS system. There was a lot the fed could have done, but didn't, under the assumption that the market would police itself.

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  11. Anonymous2:14 PM

    you then have to factor in that the gov't indices are a pack of lies that are only meant to persuade the avg person that the gov't is doing the right thing. if you fail to factor that in, you will come to all manner of faulty conclusions.

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    1. Refuted by:

      http://bpp.mit.edu/usa/

      (among other things)

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  12. then: "You can see the computer age everywhere but in the productivity statistics. ... “ -Robert Solow

    today
    "You can see the inflation everywhere but in the CPI ... “

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    1. And here again: http://bpp.mit.edu/usa/

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    2. hmmm does this online index include insurance, healthcare, tuition, gas prices and rent or is this predominately DVDs, toys, apparel and electronics?

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    3. Two things:

      1) The BPI is highly correlation and cointegrated, which presents evidence that the CPI is a decent approximation.

      2) The BPI is mostly goods, because a lot of service are not purchased online.

      3) If you want goods, services and substitution, then PCE would be a good fit for you. Note that the PCE estimate of inflation is actually quite low, so I still think you have a pretty weak case.

      http://research.stlouisfed.org/fred2/series/PCEPI?cid=21

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  13. My two cents: people do not only "consume" houses, they also "invest in" houses (unlike in beef steaks).

    That's both a reason why houses are not in the CPI, I believe, and why people believe house prices should play a role in monetary policy (i guess the idea is that houses, seen as financial assets, are like bills. hence housing bubbles are like printing bills.)

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  14. For reference, in Singapore house prices ARE included in (headline) inflation. The statistics board uses implied rents as the measure (this is 'easy' since implied rents are used for property taxes). It's also somewhat simpler in Singapore because most land is leased, thus housing is consumed over time.

    The effect in the US might be small, but there is a huge difference between 2% inflation and 3% inflation -- it's "huge" in that difference is sufficient to create a different Fed policy.

    The second argument might be 'not inflation, but a metric to consider in forecasting inflation'. The Fed cares about house prices due to wealth effect. This is particularly true because house equity can be used to generate credit expansion ... which creates spending ... which creates inflation. So house price increases might lead to future inflation. The link between house equity and credit demonstrates the a change in housing prices *is* a change in the unit of account. Since most money - credit created bank deposits - is real estate backed, a change in the presumed value of real estate does create a change in the supply of money and that converts relative house price changes into unit of account changes across all prices - ie inflation.

    Noah says " Even if the Fed really ought to respond to asset prices, the way in which is should respond is not very similar to the way in which it should respond to inflation." What this is saying is that the response to potential future inflation is not the same as the response to recent past inflation. Fair enough, but with only one hammer everything tends to look like a nail.

    Going back to the Singapore comparison - the fiscal authorities are far more nimble in Singapore. House price increases in Singapore are managed through fiscal tools (taxation).

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    1. I thought the CPI included imputed rents.

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  15. Correct if the following is way off-base, but are recent postings meant to be "troll bait" (i.e., intentionally controversial to elicit strong responses from those with a strong prior bias)? You've gone right at Japan w.r.t. supply v. demand, and now measurements of inflation... thoroughly entertaining and enjoyable, though.

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  16. John Hawkins5:41 PM

    I highly recommend this bob murphy article for the second point, about what kind of guide we should have for asset prices in the inflation index.

    http://mises.org/daily/5777/fed-policy-and-asset-prices

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  17. I think Noah is walking a fine line in this post. He is technically correct - and by that I mean, precisely, he is correct about the relationship between prices and inflation in an *instantaneous* sense. What he leaves unaddressed is that we humans don't live in or really care that much about instantaneous snap-shots.

    Inflation happens as a result of past price increases. Fuel is volatile and iffy for talking about inflation, but it's easy to appreciate. If fuel prices rise 20% and tend to maintain that new price level for a year, all wage-earners will feel the pinch, and many will sooner or later either demand a pay increase or move to better paying jobs, or jobs that require the purchase of less fuel. All of these moves will tend to cause price increases in the goods the workers produce (but in some cases, you will have to trace the effects several layers deep).

    But even more accurately, inflation also happens as a result of the *expectations* of everyone as they set their prices (including wage-earners setting their "price" for their labor). When more relevant prices rise than fall, across the spectrum of people who truly care about prices (the wealthy are far less-sensitive to almost all prices that matter to the bottom 60%), the probability distribution of the direction of price changes will be positive, and the result will be true inflation.

    Crucially, a 1-month price increase that is followed or prefaced by a similar decrease doesn't cause true inflation - but, again, the reason is that this kind of volatility doesn't change *expectations* in a coherent manner.

    That said, imagine a world where price *volatility* for all goods suddenly doubled, somehow. It's hard not to believe this wouldn't cause wage-earners to want higher wages just to cover the times when they are hit by coincidences of high prices. Volatility has a cost, even if the net change continues to be zero. Thus, price volatility is also a significant (though definitely secondary) influence on price expectations.

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    1. Nathanael10:05 PM

      Why is *everyone* forgetting wage inflation? (Apart from you.)

      I always say, "it isn't inflation unless your wages go up".

      The fact is that people actually like it if their nominal wages go up every year, even if their real (inflation-adjusted wages) stayed the same.

      Therefore we want to aim for positive inflation at all times.

      But because it's confusing and unsettling for the numbers to be unpredictable, we want prices and wages to go up at a *constant rate*, perhaps 2% per year, perhaps 5% per year. Something like that.

      This isn't very complicated.

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  18. I would do anything for meatloaf.
    But I won't do that.

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  19. Anonymous11:17 PM

    Maybe this is too much a digression, but this post makes me wonder whether the combination of monetary and fiscal policy creates sectoral inflation. Granting Milton Friedman's statement that inflation is "always and everywhere" a monetary phenomenon, it seems to me that legislation can cause any inflationary pressure to manifest itself most strongly in specific sectors of the economy. Tax-deductibility and government guarantees in the mortgage market, student loan guarantees, deficit spending on Medicare... don't these represent ways the credit transmission mechanism is distorted toward housing inflation, tuition inflation, healthcare inflation? The CPI measures the average, of course, but if policy pushes more of the money supply into these sectors, prices aren't signaling a change in relative demand, but of an uneven change in the purchasing power of the currency.

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    1. I don't like the term "sectoral inflation" either!!! :-E

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  20. And the relevant question - how and why is that a problem?

    Keynes thought about it in the GT, Chapter 22,Notes on the Trade Cycle:

    It may, of course, be the case — indeed it is likely to be — that the illusions of the boom cause particular types of capital-assets to be produced in such excessive abundance that some part of the output is, on any criterion, a waste of resources;— which sometimes happens, we may add, even when there is no boom. It leads, that is to say, to misdirected investment. But over and above this it is an essential characteristic of the boom that investments which will in fact yield, say, 2 per cent in conditions of full employment are made in the expectation of a yield of; say, 6 per cent, and are valued accordingly. When the disillusion comes, this expectation is replaced by a contrary 'error of pessimism', with the result that the investments, which would in fact yield 2 per cent in conditions of full employment, are expected to yield less than nothing; and the resulting collapse of new investment then leads to a state of unemployment in which the investments, which would have yielded 2 per cent in conditions of full employment, in fact yield less than nothing. We reach a condition where there is a shortage of houses, but where nevertheless no one can afford to live in the houses that there are.

    Thus the remedy for the boom is not a higher rate of interest but a lower rate of interest! For that may enable the so-called boom to last. The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom.

    The boom which is destined to end in a slump is caused, therefore, by the combination of a rate of interest, which in a correct state of expectation would be too high for full employment, with a misguided state of expectation which, so long as it lasts, prevents this rate of interest from being in fact deterrent. A boom is a situation in which over-optimism triumphs over a rate of interest which, in a cooler light, would be seen to be excessive.

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  21. not to argue one way or the other, but your example of house prices as 10% of the CPI fails because the shelter component is 31.587% of the CPI and homeowner's equivalent rent is 23.887%...

    http://www.bls.gov/news.release/cpi.t01.htm

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    1. This I know, but that does not mean that my example fails. If you included house prices in the CPI you'd net out shelter and equivalent rent, so as not to double-count.

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    2. my point was that a 10% increase in home prices would result in a 2.4% increase in the CPI, if it were included instead of homeowner's equivalent rent, which replaced home prices in 1983...

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  22. Kevin6:07 AM

    Noah, this is a very confusing post. You seem to want to differentiate between 2 types of price changes: the price change due to people's changing demand for particular goods and services, and the price change due to a changing definition of $1. You call the latter "inflation". But how is it possible to differentiate how much of change in the CPI comes from the latter and the former?

    For example, you write: "Most of the increase in house prices (9/10 of the increase) would not represent inflation." How do you know that this is true? citation needed.

    In terms of monetary policy, the Fed has made it clear that its focus is on inflation as measured by PCE, and not inflation in any particular asset class. Bernanke has said that the correct way to deal with asset bubbles is with microprudential policies, rather than monetary policy.

    Also, Australia's CPI does include house prices.

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    1. US CPI included home prices, too, before 1983...reasons they took it out were similar to why they leave energy out of core CPI..

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    2. Noah, this is a very confusing post. You seem to want to differentiate between 2 types of price changes: the price change due to people's changing demand for particular goods and services, and the price change due to a changing definition of $1. You call the latter "inflation". But how is it possible to differentiate how much of change in the CPI comes from the latter and the former?

      Just calculate the change in CPI and subtract it from the change in the price of the thing itself. Easy.

      Sorry that wasn't clear.

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    3. Anonymous11:35 AM

      Saying "Squirrel = Delta(prices)-Delta(CPI)" doesn't make "Squirrel" meaningful or useful. CPI is an arbitrary number designed by politicians to serve political purposes. (I must admit that given this, Squirrel could be USEFUL for political ends). Squirrel tells us nothing about the market or the economy or people's lives. It is ARBITRARY.

      Inflation is the increase in money supply per unit time. It does not necessarily result in a change in any price, and certainly not in a "general" increase in prices, however that might be defined. Inflation is typically performed by governments in order to avoid honest tax increases--Inflation is not something that governments attack, as if it were government's enemy. Inflation is a form of taxation; It also serves politicians directly, by allowing them to reward their corporate sponsors with riches hidden from the direct view of those who are only counting up the direct, honest taxes.

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  23. Anonymous7:10 AM

    What if we took away the FED put? Isn't that what you are building your foundation on in this analysis? Asset prices inflating is only as good as the next crash, when the fed has to come to the rescue. Good for some.

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    1. "Fed" stands for "Federal Reserve". It is not an acronym.

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    2. Anonymous7:31 AM

      do you think george zimmerman is a racist NOAH?

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    3. "Noah" is not an acronym either. It's short for "Noah is the awesomest guy in teh Universe".

      Delete
    4. Anonymous7:44 AM

      "teh" ain't a werd. i think it's important from a rationale thinking human-being standpoint that you aren't brainwashed by the msm(MSM) or mainstream media or a particular school of economic thought. hence, i'm curious if you personally think, based on all the evidence, if george zimmerman is a racist.

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    5. I don't make werds. I make werds better.

      And I never engage in "rationale thinking".

      Yeah George Zimmerman is probably a racist motherfucker. What's with that fake Jewish name anyway? I'm still not letting him into the Conspiracy.

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  24. Anonymous8:04 AM

    he's white too. what if creepy ass cracka was...creepy, ass cracka?
    http://www.urbandictionary.com/define.php?term=ass+cracker
    maybe, george zimmerman was a victim of gay bashing. conspiracy groweth..

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    Replies
    1. what if creepy ass cracka was...creepy, ass cracka?

      There are questions the answer to which is too horrible to contemplate.

      Delete
  25. Money is fungible. Wealth represents a collection of money. Asset inflation results in an apparent increase in wealth, which can be converted into money. A greater amount of money for the same assets represents (future) inflation.

    Asset inflation MUST be included in overall inflation considerations. However, there is a delay from asset inflation to overall inflation.

    A rapidly-inflating asset becomes a target for opportunists to make a profit, driving the asset to higher extremes (Holland tulip mania).

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    1. This isn't quite right, imho. Wealth is *not* a collection of money, wealth == equity; it is a person's (assets - liabilities). Asset "inflation" (what do you mean here?), by the definition I give, does result in an increase of wealth _by definition_, not as some sort of causal relation.

      You end the first paragraph with an assertion unrelated to the rest of the body:

      "A greater amount of money for the same assets represents (future) inflation."

      Two problems with this premise:

      1) I think you're equivocating on "inflation" here. Inflation is simply the rise in the general level of prices resulting in a fall of purchasing power (IE, a change in the unit of account). In other words, you can't single out assets, otherwise, it is a relative price change (a shift in preferences). It has to be ALL goods & services, not just one class. Noah discusses this in his article.

      2) Commodity prices surely have some role in forecasting overall price level changes, but I did some googling and found that they're not the best indicators. So your argument lacks empirical validity.



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  26. The problem with this article is that it mentions all sorts of things that are sort of kind of true, in isolation ... but it misses the fairly simple truth. Inflation is a monetary phenomenon. Why was there a housing bubble? Because the Feds pushed housing to those that didn't qualify. Where did those people get loans? From banks. Where did the banks get the $ to lend? The Fed (and international sucker "Feds"). That is inflation - because it's monetary.

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  27. John S9:49 AM

    Noah Smith (on Twitter): The hard money people appear to have abandoned the "inflation danger" line and retreated to the "financial instability" line of defense.

    Actually, the link between asset prices and macro stability was a concern of the BIS even before the crisis (there are many papers on to the topic dated from the early 2000s). And the Economist was also warning about "asset-price inflation" from the late 90's. Here's an example from 1998:

    "Thus, far from being dead, inflation may have merely assumed a different guise. And the lesson, as The Economist argued earlier this year, is that central banks should pay attention to the prices of assets as well as monitoring the prices of goods and services.

    Central banks already take account of rising share prices if they threaten to spill over into general inflation as consumers are encouraged to spend some of their capital gains. But even if a stockmarket boom has no impact on inflation (which measures the rising price of current consumption), central banks should still worry about inflation in asset prices (which reflect claims on future consumption). Just as with normal consumer-price inflation, asset-price inflation can misallocate resources in the economy by distorting price signals. Rapid increases in the prices of equities and property may encourage firms to over-invest, or investors to over-borrow, as they bet on future capital gains."

    http://www.economist.com/node/175611

    And here's Larry White (via Beckworth) in 2007 writing about asset prices and the need for a better inflation target:

    http://macromarketmusings.blogspot.com/2007/10/lawrence-white-on-right-type-of.html

    So no, this isn't just some sly backtracking on bad predictions of imminent hyperinflation. In "Boom and Bust Banking," Beckworth et al raised many of these issues (w.r.t. monetary policy and asset prices) w/o invoking the boogeyman of hyperinflation. Have you read it?

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  28. This article is simply wrong about the meaning of the word "inflation".

    "Inflation" means to puff up.

    In economics, "inflation" means a rise in general prices.

    "Price inflation" also means a general rise in prices.

    "Consumer price inflation" means a general rise of consumer prices.

    "Asset price inflation" means a general rise of asset prices.

    "Housing price inflation" means a general rise of housing prices.

    "(whatever) price inflation" means a general rise of (whatever) prices.

    There's nothing wrong and nothing the least bit misleading or confusing about the term "asset price inflation". The term itself does not imply any particular cause, though of course it's most often used in reference to a rise in asset prices caused by monetary policy that lowers interest rates.

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    1. This is wrong. Inflation in the general sense means "to puff up". Inflation in economics refers to a specific phenomenon. You are confusing the language domain, conflating ordinary, colloquial language with jargon (specialized language).

      Inflation in economics means a rise in the price level that outpaces rises in income, hence the unit of account change.

      When you say, "Asset price inflation", you are using the colloquial meaning of inflation, *not* the economic use. The mistake people make is assuming that the colloquial meaning == economic meaning, and therefore action is required to suppress asset price "inflation".

      Delete
  29. Anonymous10:28 AM

    Ok, Noah doesn´t want us to talk about inflation unless we are referring to a rise in the "overall price level".

    He says: "the real inflation, i.e. changes in the price index". The problem is that there are millions of different price indices, there is no "the price index".

    So, I am unconvinced and will continue talking about housing price inflation (in the same way Tom explains) as a general rise of housing prices and asset price inflation as a general rise of asset prices.

    Consumer price inflation... commodity price inflation, etc.


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  30. As this document from BLS researchers states, back in the day the CPI did directly include asset prices like houses in the index. After considerable research, this method was abandoned in favor of the new "rent-equivalent" method, which uses market rents to impute the portion of your house's value that is "consumed" each month. That's a pretty darn good approach, though it's not perfect (for example, the rent/price relationship varies over time, so it is possible that CPI currently overstates the true cost of homeownership). http://www.bls.gov/opub/mlr/2008/08/art1full.pdf

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  31. Anonymous7:52 PM

    "1. They think that asset prices change in response to monetary policy."

    "I could argue with either or both of these."

    You're an idiot. The only reason stock prices, commodity prices, and capital goods prices rise over the long term is because of monetary policy. More money and spending pushes prices, including asset prices, up over time.

    This article is the dumbest article I've ever read.

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  32. Nathanael10:01 PM

    "We know inflation - the real inflation, i.e. changes in the price index - is bad if it goes too high or too low. "

    I'm gonna nitpick! And this is an IMPORTANT nitpick.

    Real inflation -- inflation as the great economists use it -- means a rise in the general price level of EVERYTHING, and the SINGLE MOST IMPORTANT price in that index is WAGES.

    So a rise or fall in the CPI does NOT necessarily mean general inflation. The CPI is missing one of THE most important components of the economy.

    If wages are going the other way... it's almost certainly not "inflation".

    There should be a Producer Cost Index, and it would be likely be 90% composed of wages, with some spending on raw materials and capital. You would want to watch THAT index as well as the CPI.

    If CPI goes up and wages go down, corporate executives, or stockholders, or bankers, are basically taking money from workers. This is actually pretty much happening right now; CPI is going up very slowly, but wages are going down. This is what should be called "price gouging", not inflation.

    If CPI goes down and wages go up, the money is being shared more evenly. This... would be nice.

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  33. TheDjinni3:14 PM

    "There's only one kind of inflation, and that is inflation itself. You have to add everything in before you can tell me how much inflation there is."

    The terminology is so used to distinguish "asset price inflation" (as measured by a hypothetical "asset price index") from "inflation" (as measured by the CPI). The emphasis here is that inflation affects and can be measured by both kinds of indexes, or in particular a combination of the two.

    The fundamental concern here is whether asset prices should be incorporated into an index to measure of inflation and whether an index including asset prices could be superior to the existing CPI, which the title of this article appears to be denying. Except, you seem to be arguing the technicality that "asset price inflation is not inflation because inflation represents a change in all prices but asset prices aren't all prices"... but that's a position that nobody even contests anyways and isn't relevant to the central debate here.

    As such...

    "Most of the increase in house prices (9/10 of the increase) would not represent inflation. It would represent a rise in the relative price of houses. It would mean that people are willing to (implicitly) give up a larger quantity of back rubs, iPads, cars, and meatloaf in order to obtain a house. It would not indicate a change in the unit of account. The unit of account would remain relatively constant, changing by only one percent, even as house prices rose very substantially."

    You can make the exact same argument for everything else in the CPI. You're arguing against the concept of the CPI, not against including asset prices on the CPI.

    This is relevant because you implicitly endorse the existing CPI here:

    "Traditionally, economists do this by calculating a "price index", which is an average price level of all the useful stuff that people buy. In the first case, the price index will go up only a little, or maybe even not at all, as a result of the increase in desire for beef that led to beef's price rise. This, economists call a "relative price change". But in the second case, the price index goes up a lot as a result of the change in the unit of account. This, economists call "inflation"."

    So, does the conventional CPI suck because relative changes in demand of the individual products distort the CPI too much relative to it's goal of measuring actual inflation, or is conventional CPI sound because relative changes in demand don't really affect the CPI as a measurement of inflation to a significant degree? You're claiming the former for used houses, and the latter for beef. In what way are these distinct and why does this distinction apply to all asset prices?

    And no, you don't get to make the argument that "used housing can be used for investment purposes and therefore shouldn't be on the CPI" until you justify how a consumption-focused index (like the CPI) is the right way to measure inflation in the first place (which you can't without rescinding your definition of inflation).

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  34. I think the point of "asset price inflation" is that assets such as houses are a kind of currency. A house is a large, very high denomination coin that you can take shelter in. Sure, it's a capital good, but also a monetary instrument, perhaps increasingly the latter.

    If houses or the general level of housing tech don't improve much, but their prices rise significantly, that's evidence that the monetary value of houses inflates, or rises relative to the dollar, while their use value isn't getting more expensive. If rents don't go up that's further evidence.

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  35. Buying a house is probably the single most expensive purchase a US citizen does in his life.
    Should it not be included in the CPI?

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  36. Anonymous12:03 AM

    The first mistake in this article is referring to a house as an asset which it is not. An asset is something that brings in more money per month/year then what it costs. So only if your house brings in more then your mortgage, property taxes, utilities and maintenance costs then it is an asset if not it is a liability.
    Also if house prices increase faster then the rate of inflation you will have another housing bubble at some point. i.e. If starting pay at a job is $50k and goes up at rate of inflation say 2% the same job will now start at just over $55k but a house that was $200k and increased at a rate of 5% a year would cost $255k. That is a 10%+ gain in pay but a 27%+ gain in house price, which makes the current model unsustainable and a bubble likely to happen again. Your house is not an asset!

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