How Consumer Price Inflation and Asset Price Inflation Affect Your Finances

Consumer Price Inflation and Asset Price Inflation Compared

Inflation is a term that is often used to describe the general rise in the prices of goods and services over time. However, not all prices increase at the same rate or for the same reasons. In this blog post, we will compare two types of inflation that affect different aspects of the economy: consumer price inflation and asset price inflation.

What is consumer price inflation?

Consumer price inflation, also known as the consumer price index (CPI), measures the change in the prices of a basket of goods and services that are typically purchased by households. The CPI is calculated by taking the average of the prices of a representative sample of items, such as food, clothing, housing, transport, health care, education, and entertainment. The CPI is expressed as a percentage change from a base year, which is usually updated every five years to reflect changes in consumption patterns.

The CPI is used to monitor the cost of living and to adjust wages, pensions, taxes, and benefits. It is also used as a key indicator of the overall inflation rate in the economy and as a target for monetary policy. The main goal of the European Central Bank (ECB) is to maintain price stability, which it defines as an inflation rate close to but below 2% over the medium term¹.

What is asset price inflation?

Asset price inflation, also known as asset inflation, refers to the increase in the prices of assets, such as stocks, bonds, gold, and real estate. Asset prices are determined by supply and demand factors, as well as by expectations of future returns and risks. Asset prices can also be influenced by monetary policy, especially when interest rates are low and credit is cheap.

Asset price inflation can have positive and negative effects on the economy. On the one hand, higher asset prices can boost wealth, confidence, and spending among asset owners. They can also stimulate investment and innovation by making it easier for firms to raise capital. On the other hand, higher asset prices can create bubbles and instability in the financial system. They can also widen inequality between asset owners and non-owners. Moreover, higher asset prices can spill over to consumer prices by increasing the costs of production and consumption.

How do consumer price inflation and asset price inflation compare?

Consumer price inflation and asset price inflation are not necessarily correlated. They can move in different directions or at different speeds depending on various factors. For example, consumer prices can rise faster than asset prices when there are supply shocks or cost-push pressures in the economy. Conversely, asset prices can rise faster than consumer prices when there are demand shocks or easy monetary conditions in the economy.

In recent years, many advanced economies have experienced low consumer price inflation and high asset price inflation. This phenomenon has been attributed to several factors², such as:

• Globalisation and technological change, which have reduced the costs of production and increased competition in goods and services markets.
• Demographic change and low productivity growth, which have reduced the potential growth rate and increased saving relative to investment.
• The prolonged period of ultra-low interest rates and unconventional monetary policy measures implemented by central banks in response to the global financial crisis and the COVID-19 pandemic.
• The fiscal stimulus packages adopted by governments to support economic recovery and mitigate social hardship.

What are the implications for monetary policy?

The divergence between consumer price inflation and asset price inflation poses challenges for monetary policy. On the one hand, low consumer price inflation may justify keeping interest rates low and providing ample liquidity to support economic activity and achieve the inflation target. On the other hand, high asset price inflation may warrant raising interest rates and tightening financial conditions to prevent excessive risk-taking and financial imbalances.

The ECB has adopted a flexible approach to balance these trade-offs. It has maintained an accommodative monetary policy stance to ensure favourable financing conditions for all sectors of the economy¹. At the same time, it has monitored closely the potential side effects of its measures on financial stability². It has also called for macroprudential policies to address specific risks in certain segments of the financial system². Moreover, it has launched a strategy review to assess whether its monetary policy framework needs to be adjusted to better reflect changes in the economy¹.

Conclusion

Consumer price inflation and asset price inflation are two different types of inflation that affect different aspects of the economy. They can move independently or diverge depending on various factors. The ECB has taken a flexible approach to deal with these challenges and ensure price stability in the euro area.