Why doesn't the Fed consider asset price inflation to be inflation?

Question

Why doesn't the Fed consider asset price inflation to be inflation?

Answer 1

This is a good question, and one that is asked a lot in finance circles.  I have two answers, the technical textbook answer, and my own opinion.

Theory:

Counting an increase in asset values would be double counting the impact of inflation.  Inflation is the difference in growth rates between the money supply and economic activity (GDP or national income).  Assets have value because the produce a flow of value- stocks provide dividends, houses provide a place to live, etc.  Inflation measures the increase in the dollar value of the same value flow.  Thus, even if an asset hasn't changed, it will be worth more dollars because a dollar doesn't go as far.

As long as you are measuring inflation in the value flows from the asset, you don't need to directly measure it in the value of the asset.

My Opinion:

The Fed *does* look at asset prices ever since Greenspan.  The stock and housing markets aren't always efficient, and at times becomes disconnected from the underlying value flows.  When that happens, the Fed will sometimes raise rates to calm the market, as in the late 90's.

Answer 2

Interesting question, but you really mean is why the Fed doesn't act against asset price inflation as it does against the more conventional sort.

The real answer to that no one really knows, though it is clear that it is an explicit decision on their part. There have been numerous papers on the subject over the years, including this one from the Fed in 2002:

http://search.ssrn.com/sol3/papers.cfm?a...

and this one from a Fed governor in 2006:

http://www.federalreserve.gov/newsevents...

and even now, they give the same arguments:

http://www.federalreserve.gov/newsevents...

And, of course, the topic has been particularly hot since the damage the real estate bubble did to the Japanese economy has become clear, so this issue was by no means a peripheral one, even before the subprime fiasco.

But, since one can never assume that what they say is what they are really thinking, one can only speculate.

My thoughts include:

1. Directly dealing with asset inflation would make their job much more difficult. They are already trying to balance at least half a dozen other inflation indicators.

Related to this is the fact that in general, asset price inflation does not hit the economy in as uniform a manner as do other types of inflation. That means that acting effectively against asset inflation will tend to do more harm than against other sorts of inflation.

2. They have a philosophical bias in favor of the market and against restraining it. The most conservative economists don't even want the Fed paying attention to inflation at all - just to the money supply - and the Fed has resisted an explicit inflation target of the sort many other central banks have. Looking for additional  opportunities for intervention strikes them as immoral.

http://www.catallaxis.com/2005/07/asset_...

Greenspan, for example, is known to be a fierce Libertarian and has written that businessmen know better than to do the sorts of things that have lead to the recent asset bubbles in the U.S.

And the more recent papers from the Fed argue that the answer is "better regulation", even though the Fed hasn't been making full use of the regulatory powers it has.

3. General price inflation is generally clearly visible. While many people will complain when the Fed  raises its reserve requirements, etc. saying "it is too early", overall, there is a general understanding of the Fed's moves. With actions against asset price inflation, more people are going to complain - primarily the rich making lots of money off the boom, people who have the ear of the president, etc.

William McChesney Martin, once chairmen of the Fed said that the job of the Federal Reserve is "to take away the punch bowl just as the party gets going,"

http://en.wikipedia.org/wiki/William_McC...

No one likes the guy who does that.