Households' balance sheet recovery is encouraging

Today the Federal Reserve released its estimate of U.S. households' balance sheet as of the third quarter. As the chart above shows, household net worth has increased since the end of the recession, thanks mainly to the recovery in the price of financial assets (higher stock prices and higher bond prices). Real estate values have slipped a bit from the levels of early last year, but this has been offset by a decline in debt. So the big picture here—aside from the regrettable fact that net worth is still about $11 trillion shy of its 2007 high—is one of a noticeable shift in relative prices: financial asset prices have increased relative to real estate values since the end of the recession. Is this unprecedented or unsustainable? Not at all, as the next chart shows.

This chart compares the annualized rate of inflation (on a 3-yr rolling basis) to the ratio of households' holdings of tangible assets as a % of total assets. The chart (or one like it) was originally created by John Rutledge in the early 1980s to show how inflation impacts the prices of tangible and financial assets. Easy money, and the rising inflation that follows, reward those who own real estate and tangible assets in general (e.g., commodities) and penalize those who own financial assets (because interest rates rise), so it's not surprising that we saw a big upturn in tangible asset prices relative to financial assets in the late 1970s as inflation rose. By undermining the demand for money, rising inflation boosts the prices of non-money "things," while it erodes the value of money itself. By the same logic, it was not surprising that the big decline in inflation in the 1980s saw a big reversal of that relative price shift, as financial asset prices boomed and real estate values rose only modestly.

Curiously, however, while the housing boom of the 2000s caused a surge in real estate values relative to financial assets, we didn't see much of an increase in inflation. That may explain why the real estate boom ended up a bust: inflation never got enough momentum to boost incomes, so rising home prices soon became unaffordable, and that was the root cause of the subsequent price collapse.

Another thing that strikes me about this chart is the fact that the ratio of tangible to total assets has come back down to a level that prevailed in the low-inflation 1960s, up until the inflation of the 1970s hit. 

In a similar vein, Calculated Risk has a nice chart (below) which shows that household net worth as a % of GDP has come back down to levels that prevailed in the early 1960s, and close to the trend level that has prevailed since 1952, after surging briefly in 2000 (the dot-com boom) and 2005-06 (the housing boom). Bubbles can get surprisingly big and last longer than one would think, but eventually they burst. I would argue that from these two perspectives (net worth as a % of GDP and the ratio of tangible to financial assets), there has been enough price adjustment in recent years to restore some semblance of equilibrium once again. In other words, there is no a priori reason to expect a significant further deterioration in real estate prices or net worth, especially with monetary policy being so accommodative that it could begin encouraging another rise in real estate prices (and here I note that commodity prices are at all-time highs and rising), but not yet so accommodative that it is likely to destroy financial asset prices via double-digit interest rates.