Inflation and Asset Prices

John A Tatom

Changes in the general level of prices and inflation have profound effects on asset prices. There are several reasons for these effects and the influence differs depending on the source of the inflation and whether it is expected or not. To understand these effects, it is important to clarify what is meant by inflation, the pure theory of the sources of inflation, how inflation affects the prices of goods and services and how it affects both the equity prices and fixed income assets that are used to finance production.

Inflation has had large effects on asset prices in the US, especially during the Great Inflation from 1965 to 1984. There have been lesser bouts of inflation since then, and an acceptable and stable pace of inflation for more than a few years at a time has been elusive. The Great Inflation was followed by the Great Moderation (see Chapter 1), a reduced volatility of real GDP growth, which some analysts argue was caused by improvements in monetary policy in pursuing lower and more stable inflation (Bernanke 2004). Blanchard and Simon (2001), for example, documented that the variability of quarterly growth in real output (as measured by its standard deviation)