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PostWhere is Inflation? Look at the Stock Market (from Michael Frank) (John Eipper, USA, 03/07/21 7:42 am)
Michael Frank explains:
What I intended to say in yesterday's post was that if interest rates are zero, the net present value of a penny of future return is a penny. So any investment that produces steady returns has infinite value. I'm at that awkward age, where the mind is willing, but the keystrokes don't cooperate.
To understand this, imagine that I promise to pay you $10 one year from today. If interest rates are 10% annually, then the value of that promise is a hair under $9.10 (Because $9.10+ $.91 interest = $10.01). If interest rates drop to zero, then this promise is worth the full $10, because a dollar in the future is worth a dollar today.
To understand how this works for financial assets, imagine that a company will pay you an endless stream of $10 annual dividends and that the prevailing interest rate is 10%. Next year's payment is worth $9.10, and the payment for the second year is worth less, about $8.30, because it's further out in time. The third year's payment is worth $7.55. The further out in time, the less the payments are worth. Eventually, the value of the additional payments becomes inconsequential, because they are discounted at a 10% compound rate. As long as I can make an educated guess as to the cash flow over the next few years, the time value of money gives me a rational way to price the investment.
Now the same exercise with zero rates. The present value of next year's payment is worth $10. And the second year's payment? Also $10. And so on ad infinitum. So as zero interest, a dollar at any future point is worth a dollar today. If I can reasonably expect that the operation will continue indefinitely, the price of the investment will approach infinity. Or at least, it's going to be absurdly expensive. So pricing may come down to hand waving and storytelling.
Everyone frets about inflation and wonders how in the world we can keep increasing debt without affecting prices. Because so much of this new cash transforms into concentrated wealth, financial asset prices have spiraled upwards. My unconventional definition of inflation: too much money chasing too few securities. If you want to find inflation, throw a dart at the Wall Street Journal. Easy money has made a mockery of asset pricing.
JE comments: I follow this, Michael. And you've put inflation into harsh perspective: it's already here, in the securities markets. And how about real estate? Given their impact on monthly payments, low interest rates equate with inflated prices.