Asset bubbles and inflation - what is the correlation?

Asset bubbles are created when an entity, such as the Federal Reserve, removes the moral hazard of investing and ownership in that asset class. This causes over investment in that asset, or collection of assets, such that prices become misaligned to their intrinsic value.

How does this happen? Moral hazard is a term that represents the risk of ownership or investment in something. When the risk of owning that “something” is removed, by the actions of a government to bail out the investors of that something (some type of investment vehicle or asset), then the investors feel that they can’t lose. Investors will then bid up the price of that asset, until it is so out of whack with its fundamental value that the price becomes unsustainable.

What does this have to do with inflation? Most economists would say that asset bubbles have nothing to do with inflation, in that inflation is generally considered to be defined as the increase in prices of consumer goods, also known as consumer price inflation (CPI). Whereas, asset bubbles, or asset price inflation, is generally considered to be the increase in prices of “hard” goods, like housing (real estate), gold (precious metals), or art (collectibles). Other assets, like stocks and bonds, or other asset classes, can also experience asset price inflation.

What is the correlation? I bring up the subject of asset bubbles and inflation, because we are experiencing and living in a unique period of our economic history. The US Federal Reserve is performing an unprecedented experiment with our national economy, by ballooning the total Fed balance sheet from $1.5 to $4.5 trillion, while holding interest rates near zero from 2008 to 2015. That money has to go somewhere, and it has been used by corporations and investors to drive up prices in stocks, real estate, and other asset classes for over 10 years. The result of this asset inflation will be future price inflation, as asset inflation usually precedes periods of high consumer inflation.

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