Veteran readers know it’s always been a part of the Financology canon that inflation is a decline in currency value that affects asset prices first, consumer prices later. As far as I recall however, we’ve never really dug into why that is or how it happens. It’s not particularly complex, but it does call on one’s powers of abstraction.
First let’s talk about securities in general. The most important are stocks, bonds, and currencies. Each is something that has no utility by itself. You can’t eat them, live in them, or even make them into jewelry to delight your sweetie. Their only use to you is as claim tickets on things that do have intrinsic utility.
They have much more in common with each other than they differ. Stocks and bonds are both obligations of someone else, essentially debts that are owed to the holder. In the case of bonds, the amounts are contractually fixed in advance, with stocks, they are contingent on the financial success and integrity of the issuer. They typically, but not universally, pay the holder some periodic consideration for the use of his capital. In the case of bonds it’s called interest and in the case of stocks it’s called dividends.
Currencies are issued by banks. They too are debt obligations. Like stocks, they may not be obligations to pay anything specific, but historically they may have been backed by silver or gold, and increasingly by government debt … essentially whatever the bank holds on its balance sheet. They don’t usually pay any interest or dividends.
For our purposes here though, it’s what they all have in common that is of primary interest. And that is that their use to the holder is as claim tickets on things that have intrinsic utility. And that their value to the holder ultimately depends on the latter.
This is not merely a theoretical abstraction, but has very practical implications to our axiom about asset and consumer prices.
At any given moment, there is a fixed amount of these things of intrinsic utility available in exchange for these claim tickets. This body of goods and services does not fluctuate with asset prices. There exists tomorrow for instance a certain amount of stuff in the world. The purchasing power of the sum total of all the securities … stocks, bonds, currencies … is equal to the amount of stuff available for purchase.
If for example the price of stocks increases by 5% between today and tomorrow, the value of this total is unchanged. This means the purchasing power of bonds+currencies must have declined. If the prices of stocks and bonds have both increased, the purchasing power of currencies must have decreased.
Now let’s turn to the differences between these types of securities. When we go to redeem our claim tickets, we don’t ordinarily exchange stocks or bonds directly for these things of intrinsic utility. We first exchange them for currency, then exchange the currency for the latter. The distinguishing characteristic of currency is hinted at by the name we give it … it is the asset we use for current consumption.
Stocks and bonds, on the other hand, are used almost exclusively to store purchasing power for future use.
At this point it may begin to become clear why declines in the value of currency show up first there, and how stocks and bonds in effect can serve as a reservoir to store inflation only to later become apparent in consumer prices.
When the purchasing power of a currency first declines, prices of stocks and bonds rise. For starters, consumer goods and services don’t trade in real time auction markets, where prices adjust instantly, tick by tick, to changes in the value of currency. And people’s consumption needs aren’t instantaneously affected by them either. If you were going to buy a ham sandwich today or a washing machine tomorrow, your plans aren’t going to change just because the central bank created a billion new dollars overnight. And chances are you didn’t receive any of those dollars either. Instead, what you will notice, if you have them, that the prices of your stocks and bonds rose. This is purchasing power that you will use later.
But all the while, the total purchasing power of all the world’s securities is unaffected by their relative values. It is affected only by the body of goods and services available for purchase. So increases in the value of stocks and bonds equate to decreases in the value of currencies. So long as this purchasing power is stored for later use, however, the decreases are not obvious.
So the initial effect of a decrease in the value of currency – inflation – is to create the appearance of an increase in prosperity. As long as you’re not trying to spend it, you are able to assume that you have gained wealth. This is an economy-wide effect. Society believes its wealth has increased. Yet aggregate wealth is unchanged.
We’ve seen this effect empirically in broad cycles over economic history. First asset prices rise, then consumer prices. Asset prices may then fall as policymakers belatedly attempt to counter the rise in consumer prices. Asset prices rose strongly in the 1950s-1960s. In the 1970’s, consumer prices surged, while asset prices fell. Asset prices rose in the 1980s-1990s. In the 2000’s, consumer prices rose and asset prices fell. In extreme cases, the effect can be seen over shorter time frames. In 2020-2021, asset prices soared. In 2022, consumer prices followed suit, as asset prices fell. In all cases large increases in asset prices are either reversed or consumer prices rise to meet them. Or some messy combination of both.
In sum, broad increases in asset prices represent the first obvious sign of inflation. They are perceived as a sign of prosperity, but in fact reflect a decrease in the value of the currency, which will later either be reversed or show up in consumer prices.
Or some messy combination of both.