I have never liked the word “inflation” in any context. It is far too subjective despite the various ideological attachments that have been assigned. However, humans, as economic agents, perceive “inflation” and it has very real effects on economic decisions and performance, so it has to be accounted for in some way.

Inflation in the conventional economics sense is narrowly defined as the “general” rise in prices. In other words, if the prices of milk and eggs double but the prices of iPads and iPhones halve, there is a rough equivalence that does not count as “inflation” in the conventional sense. Since prices change all the time and in relation to other goods and services, there is logic to discounting “inflation” where the “general” rise in prices is largely absent.

But where that comes apart is in the intuitive knowledge that there is no such uniformity outside the economic classroom. It could certainly be the case that some people feel the effects solely of pricing in milk and eggs doubling and have no experience of the iPad “offset”. It is even “more true” that there are varying degrees to which both changes effect individual agents.

The common perception about inflation as it relates to “money” (which is never really defined; in the modern age it really needs to be – is a eurodollar money since it is not at all usable by any economic agent in its existing format? It can be transformed into spendable dollars by banking agents in their accounting conventions that lead to credit growth, and thus in a usable format) is in the unit of account. If the “general” price level doubles, the reciprocal interpretation is that the dollar was cut in half. And that is a very valid intuitive framing.

Left unsaid is why the dollar lost half its value. Intentional devaluations are exceedingly rare, such as 1934 when, after confiscating private gold in 1933, the Roosevelt administration changed the “value” of the dollar relative to gold (the anchor). That devalued the dollar and changed the monetary equivalence with foreign counterparties, resulting in a massive inflow of gold into the US. It was the flow of “money” that mattered, not the administratively set dollar “price”. That gold inflow, in turn, increased the “money stock”, largely credit, and led to “general” wholesale price changes interpreted as inflation.

The process of conventional inflation is similar. Think of the Great Inflation of the late 1960’s and 1970’s. Modern economic and monetary thought has moved a degree away from “money growth” as the proximate cause of inflation and into “expectations” theory. In other words, perceptions of monetary factors lead to actions which dictate behavior, and thus bleed into changes in prices. If those perceptions flow through wages then it tends to form consumer inflation, the “cost-pull” variety.

But even in this derivative interpretation, there still exists the monetary linkage. In other words, perceptions of “inflation” are grounded in perceptions of monetary conditions, and, more importantly, future monetary conditions. That is the crux of the “rational expectations theory” which posits that economic agents will act today on their perceptions of what will happen in the future. Thus, if the Fed threatens to increase the “money supply”, however defined, economic agents are expected to behave according to an inflationary expectation – this is the theoretical basis for QE and negative interest rates.

Somewhere embedded in this theoretical miasma is the equation of exchange: M * V = P * Q (or y). Changes in money stock (M) with constant velocity (V) should yield either an increase in general prices (P) or economic activity (Q) or national income (y). I have serious problems with the equation of exchange, mostly in the idea of V, but there is an intuitive validity to the idea here on some level. If you are an adherent to aggregate demand theory, holding V and P constant makes M and Q equivalent or substitutes.

The problem of translating that to the real world is the complexity I alluded to above. There are a vast array of choices, decisions and outcomes that complicate and muddy the potential translation of M into Q. Not the least of which is P.

However, the original equation of exchange was not as cited above, it was actually M * V = P * T, where T is all potential transactions. It comes from the work of John Stuart Mill and philosopher David Hume. The formulaic presentation is the work of Irving Fisher, inclusive of the use of T rather than Q.

There have been many changes over the years, including the work of John Maynard Keynes who posited that not all money gets included or used in transactions, and that there exists a dynamic liquidity preference rendering some of it moot. My point here is not that there is a mathematical validity or precision to the equation of exchange in some form, evolved as it has, but rather that the basic idea has been maintained in economics for hundreds of years because we intuitively feel these operations and relations in our own sense of individual economics. Rational expectations theory, used horribly to justify what is really statism through the soft central planning of central banks, is a valid interpretation of behavior on its face.

In that original idea where T predominated, the economists surmised that money can be used not just for the purchase of goods and services, but also economic and financial assets. That leads to the idea of potentially figuring not only consumer inflation but also asset inflation.

The very mention of asset “inflation” enflames and enrages conventional economists since it was banished as an idea decades ago, at least from the mainstream canon. But it certainly fits in the real world circumstances where “money” is not uniform. If the Fed ncreases the level of credit through interest rate targeting, should we not expect that banks and financial agents would direct some of that “money stock” into the chase of asset prices (particularly as volatility rises through unstable money)? Banks, particularly the investment banking model through the shadow system, are not in any way limited to intermediating solely with real economy obligors.

In this manner, banks act not only in intermediation of selecting obligors and recipients of credit “money”, but also the placement through asset classes (including equities, real estate, derivatives and even other “currencies”). The banking system directs the decidedly non-uniform flow of “money” globally.

I don’t think there is anything particularly controversial about that, but is it “inflation”?

The biggest problem with asset “inflation” is the lack of a readily apparent anchor; the measurement problem. How do we know when stock prices are in a bubble vs. the “normal” and expected rise in stock prices? Is it, like pornography, simply indefinable but we know it when we see it?

There is an equivalence here that we should be mindful of. When the price of eggs and milk (and gasoline) rise and these goods get more expensive, we perceive varying degrees of inflation, mostly relative to incomes. That is why CPI measurements in various countries use different weightings in their baskets of goods to be measured. Food prices in the Chinese CPI, for example, receive a much higher weighting than the US CPI. So changes in relative levels of “affluence” seem to matter in perceiving inflation, even in the idea of price changes relative to one another.

Rapidly rising asset prices, including stocks, above and beyond income growth, then, would have the same effect – stocks would be perceived as being more “expensive”. If that perception became widespread, we would expect that investors would stop buying them at the margins and prices would eventually get less “expensive”. This is certainly true for milk and eggs and gasoline – as long as there exist substitutes or choices, prices should behave as I described. Investors have substitution choices as well, acting as an anchor on pricing behavior.

But what if there were a steady flow of “money” that bought stocks regardless of their relative “cheapness”? What if, as marginal investors perceive an “expensive” market and begin to withdraw, general stock prices do not become “cheaper”? What if there is a flow of non-investment “money”, directed to not only stocks but the investment substitutes as well?

What you get then is the financial equivalent of the Great Inflation, where asset prices rise all over the place relative to incomes. There is no real economy hardship equivalent to consumer inflation, however, and thus this asset imbalance does not register readily as “inflation”, but the behavior and how it modifies the real economic system is equivalent. And that is what is most important.

Again, inflation is not a uniform phenomenon. Some agents benefit while the harmful aspects do not uniformly accrue to all participants. Some see this as rising inequality, but this non-uniformity creates inorganic distortions to the economic system. The same is true for asset “inflation”, it is non-uniform in its effects and it distorts the economic system along the lines of inequality.

We know this because domestic monetary policy in the age of fiat has “successfully” engineered the “wealth effect”, except that in this case it is not wealth but distortion. As prices rose due to the effects of non-investment “money” on asset classes (interest rate targeting leading to balance sheet expansion and the all-consuming addition of systemic leverage) the real economy was transformed into the “consumer economy” that we know today. In other words, investors perceived an increasing dichotomy between asset prices and their incomes, but unfazed, simply replaced expanding consumption based on earned income and wages for this debt supplementation – all predicated on asset prices behaving like inflation.

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As a practical matter, the Federal Reserve under Greenspan and then Bernanke used credit growth as an economic “fudge factor” whereby marginal changes (such as minor recession) in economic activity were “filled” with increasing usage and accumulation of debt, including consumer credit and mortgages. As long as asset prices could be maintained on a consistent trajectory, investors would ignore “expensive” perceptions and continue to accumulate debt and create this inorganic, “inflation”-related marginal activity.

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It was an illusion, a distortion created by the non-uniformity of “inflation”. I understand the impulse to reject the classification as “inflation”, but that is a discussion of semantics. What we have are two related phenomenon closely linked by intentional monetary imbalances. The only difference, at least as it pertains to flow and the interplay between them, is that banks can direct marginal non-investment money to the real economy or the financial economy.  Central bank liquidity backstopping creates different incentives for banks and connected firms that do not conform to what we might normally consider perceptions of “cheap” or “expensive”.  In this case, what I call non-investment money is simply central bank liquidity promises transformed into the chase for volatility, and thus separating reasons and behavior of this bank class of “free money” investor.

We know asset inflation exists by the distortions it has left behind. Not only is there a badly imbalanced consumer economy left to pick up the pieces of these distortions, there are millions of empty residential dwellings left as testament to it. All those inorganically allocated resources were the result of individual economic agents trying to capitalize on the non-uniformity that is consistent with inflation and attendant volatility. Instead of demanding increases in wages, Americans supplemented themselves to the indebted end of the nefarious “wealth effect” as some sense of protection (or projection?) of living standards. Or, as in the case with both the dot-com and housing bubbles, they exuded irrational exuberance in the pursuit of “easy money”. That is inflation effects to the fullest, simply channeled in another direction.

Behavior is what counts, as it relates to distorting economic function. Perceptions of imbalance carry out these distortions as they are an accumulation of non-uniform monetary effects. If “inflation” is the wrong word, fine. Call it something else, but don’t dismiss it as non-existent, there is far too much economic and financial wreckage to be so obtuse.


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