What is asset inflation?
Asset inflation is when the prices of things like stocks, bonds, real estate and other investments go up a bunch. It’s different from regular inflation, which is when the prices of everyday things like food and gas increase. Asset inflation specifically looks at the rising prices of investment assets.
Why does asset inflation happen?
A few key things tend to cause asset inflation:
Low interest rates
When central banks set interest rates super low, it becomes really cheap to borrow money. This leads more people and companies to take out loans to buy assets like houses or stocks, driving up demand and prices. Low rates also make assets seem more attractive compared to leaving money in the bank.
Lots of money floating around
If there’s a ton of money sloshing through the economy and financial system, thanks to stuff like government stimulus or central banks creating new money, that cash often flows into assets and pushes up prices. More money chasing after a limited supply of assets means higher prices.
Speculation and FOMO
Sometimes people pile into certain assets because they think prices will keep going up and they don’t want to miss out on big gains. This speculative buying can create a feedback loop where rising prices attract more buyers, driving prices even higher, until the bubble eventually pops.
How asset inflation affects the economy
Asset inflation can have some major impacts on the broader economy:
The wealth effect
When the value of people’s assets rise, they feel richer and tend to spend more, even if their regular income hasn’t gone up. This wealth effect can boost economic growth in the short-term. But it can also be dangerous if people go too far into debt or the inflated asset prices turn out to be a bubble.
Worsening inequality
Asset inflation often benefits the wealthy way more than regular folks, since the rich tend to own way more assets like stocks and investment properties. This can make inequality worse if incomes don’t rise as fast as asset values. The rich get richer while everyone else falls behind.
Distorted investment decisions
Sometimes companies make bad investments or mergers during periods of asset inflation, because they have access to cheap funding or overestimate growth. It’s easier to raise tons of money and overpay when markets are bubbly. But those mistakes become obvious once asset prices fall back to earth.
Examples of past asset inflation
We’ve seen some dramatic examples of asset inflation in recent history:
The 1980s Japanese real estate bubble
Japan had crazy asset inflation in stocks and commercial real estate in the late 1980s. There was so much speculation that the grounds of the Imperial Palace in Tokyo were worth more than all the land in California. Then it all came crashing down.
The dotcom bubble
The late 1990s saw massive inflation in the stock prices of internet companies, even ones with no profits. The NASDAQ index rose over 500% from 1995 to 2000 before losing 80% of its value in the dotcom crash.
The mid-2000s US housing bubble
US home prices soared over 80% from 2000 to 2006, driven by low interest rates, lax lending standards and lots of speculation. But the bubble popped, triggering the global financial crisis. Housing played a big role in asset inflation.
The dangers of irrational exuberance
Asset inflation feels great on the way up. Everyone thinks they’re getting rich! But the problem is that inflated asset prices often get way out of whack with economic reality. Trees don’t grow to the sky, as they say.
When asset values get too divorced from fundamentals, it’s often a sign of unsustainable “irrational exuberance,” as former Fed chair Alan Greenspan famously put it. Everyone’s making too many risky bets because overconfidence is running rampant.
But eventually gravity kicks in, and what goes up comes crashing down. The bigger the bubble, the more painful the bust. And when collapsing asset prices ripple through the financial system, it can trigger nasty recessions and huge job losses in the real economy.
The tricky task of fighting asset inflation
Central banks and policymakers face a tough challenge in trying to prevent or deflate asset bubbles. Raising interest rates or tightening regulations can help cool off speculation. But it’s a delicate balance.
Move too early, and you risk unnecessarily hurting the economy. Wait too long, and a giant bubble may already be set for a devastating pop. It’s hard to get the timing just right.
Many argue central banks shouldn’t try to target asset prices anyway and should only care about consumer inflation. But in our financialized modern economy, asset inflation has huge impacts that are hard to ignore.
Asset inflation in the 2020s
The 2020s have already seen some big asset price spikes, from meme stocks to crypto to housing (again). Near-zero interest rates, government stimulus, and pandemic savings have pumped up plenty of bubbles.
But with inflation surging and interest rates rising fast, the era of easy money is over. That spells trouble for inflated assets. We’re already seeing big price drops in speculative areas like tech stocks and crypto. More turbulence likely lies ahead.
The key question is whether asset prices can deflate gradually or if bubbles will burst violently like in the past. Either way, investors who got too used to effortless gains face a rude awakening. Don’t be surprised to see some big-name casualties in the next few years.
We may be at a major turning point as the unsustainable excesses of the last bull market unwind. Buckle up and stay cautious out there. When the tide goes out, we’ll see who’s been swimming naked, as Warren Buffett likes to say. Don’t be caught in the undertow of collapsing bubbles.
