During the bull run of 2003-07, a whole range of asset prices—including equities all over the world and house prices in several countries—zoomed, but consumer price inflation was very limited. Now, the situation is exactly the reverse— while asset prices are coming down, consumer prices are rising. Inflation is a global phenomenon, with global consumer prices rising at an annual rate of 5.5%, according to International Monetary Fund (IMF) statistics, compared with less than 4% in recent years. What has led to such a drastic change?
There’s a very simple explanation: years of rising asset prices are followed by years of higher consumer inflation. A 2003 paper of the Indian Institute of Management, Kozhikode, by Bala Batavia, Parameswar Nandakumar and Cheick Wague asked the question: Asset Prices and Inflation—is there a predictive link? There are several reasons to presume such a link exists. High asset prices lead to changes in the wealth of people and this wealth effect then leads to higher consumption and expenditure, raising demand in the economy. While this may not be true for a country such as India, where stock ownership is not widespread, the wealth effect operating in the US, if it raised consumption there, would have led to an increase in goods and services being sourced from countries such as China, increasing production there and ultimately increasing demand. Also, when equity prices rise, firms can access capital easily, which leads to an investment boom, again increasing demand. Another theory says that asset prices contain information about future expected inflation and since actual inflation adjusts to expectations, asset price rises are actually nothing but predictors of future inflation.
The authors of the paper draw attention to the UK experience in the late eighties. “Easy credit conditions fuelled housing prices, which reached an inflation rate of 35% in 1988 and stock prices also rose sharply, doubling between 1985 and 1987. But CPI inflation remained at around 4% during this period. However, consumer inflation responded later, rising to 9% in 1990, so that in hindsight it would be possible to say that the sharp rise in asset price inflation in the late eighties should have been taken as warning signals for future goods and services price inflation,” they write, citing well-known monetary economist Charles Goodhart.
The authors examined the data for several countries and found that the effect of stock prices, albeit with a lag, were found to be significant for explaining consumer price inflation for Sweden, Italy, the UK, India and Korea. For India and Korea, a lag of nine quarters was found, while the lag was eight quarters for the rest. The conclusion: asset price inflation, including inflation in house prices and in stocks, do have a role in predicting consumer price inflation.
Similar conclusions were arrived at by Tim Congdon, one of Britain’s leading economic commentators. In a monograph on Money and asset prices in boom and bust, Congdon pointed out, “Because of the link between assets and goods markets, asset price booms play a major part in the development of general inflation that inevitably follows a period of lax broad money growth.” Other researchers have argued that while rising house prices are a leading indicator of more general inflation, higher stock prices are not.
The argument appears a very plausible one—after all the global asset price inflation of the last few years was indeed accompanied by global growth that was well above average. Data from the IMF show that world growth was 4.9% in 2004, 4.4% the following year, 5% in 2006 and 4.9% in 2007. That’s the first time since 1980 that global growth has been above 4% for four years at a stretch. As a matter of fact, in the years from 1980 to 2004, global GDP growth has been above 4% only in 1984, 1988, 1997 and 2000. It’s not much of a surprise then that resources have been stretched to the limit by the unprecedented growth surge of the last four years. The surprise was that in spite of such strong growth, global inflation during the period was among the lowest since 1980. That is what spawned all those theories of the Great Moderation: the belief that globalization had led to the demise of inflation, as low-cost producers that had recently entered the global capitalist system reduced costs of finished goods dramatically. The problem is that while it’s true that prices in the developed world have fallen for many manufacture products and services, the growth has created an insatiable demand for commodities, where it’s not so easy to ramp up supply rapidly. Supply bottlenecks have led to rapid inflation.
What of the future? Another way of looking at asset price booms is to see the impact that they have on lending. When asset prices are high, loans against the collateral of thosehigh prices are made and when asset prices collapse those loans turn bad. That’s exactly what’s happening in subprime mortgages.
Moreover, with the US central bank having little option but to reduce interest rates to support its financial system, it has reduced interest rates sharply, setting the stage for a continuation of the asset price inflation. No wonder the MSCI US index has outperformed the world index this year, falling 4% in the year to 13 May compared with a decline of 5.9% for the MSCI World index. Since equity and other asset markets have been unnerved by the credit crisis, this money is flowing into commodities, which has been a recently discovered “asset class”. The excess liquidity that buoyed stock prices till yesterday is now pushing up commodity prices.
Mint’s resident market expert Manas Chakravarty looks at trends and issues related to investing in general and Indian bourses in particular.
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