High asset prices, not low interest rates, are driving inflation

High asset prices, not low interest rates, are driving inflation This article was originally published in the Financial Times on 24 August 2026. Perhaps there is no better example of the K-shaped nature of the US economy than the fact that employee compensation has fallen to 50 per cent of GDP, its lowest level since 1947, while household net worth is close to an all-time high of 546 per cent relative to GDP. This dichotomy helps explain the resurgence of socialism among younger Americans. Gen Z depends disproportionately on wages, whose purchasing power has been eroded by inflation, while baby boomers hold much of the country’s accumulated wealth. It is this wealth effect that is increasingly responsible for the inflation that remains in the US economy. Excluding shelter, core inflation has been relatively stable at about 2 per cent for the past three years. The stickiest components of inflation are related to housing, restaurants, travel and other services where demand is tied to wealth. If Federal Reserve chair Kevin Warsh is committed to bringing inflation to target, he will need to slow the growth in asset prices. High stock prices are not a problem if justified by fundamentals, but returns are increasingly driven by abundant Fed liquidity and corporate borrowing. Reducing the Fed’s balance sheet, addressing bank capital rules and making clear to markets that the Fed “put” — the assumption that it will rescue investors from large losses — is very out of the money is the best way to slow the wealth effect, and tackle persistent inflation. Historically, the Fed dealt with high inflation by raising short-term interest rates. But today, wealth distribution in the US makes this tool much less effective. In fact, short-term interest rates might already be restrictive to the real economy. The latest employment report showed negative job growth, while private payrolls are growing at only 0.5 per cent annually. The only reason unemployment has not risen is because labour supply has weakened alongside demand. The Fed can still credibly argue the labour market is not the reason inflation is above target. At the same time, the stock market is at all-time highs and AI companies are raising hundreds of billions of dollars despite substantial uncertainty over the eventual return on that investment. Monetary policy is clearly not restrictive to financial markets. It is here where the other arrows in the Fed’s quiver — its balance sheet, regulatory powers, communication methods — can help deal with asset-price-driven inflation. First, the Fed should resume shrinking its balance sheet. It made a mistake last December by expanding it, rather than increasing reserves in a more targeted way. This year, US money supply has grown at almost double the pace of the previous two years, supporting reflationary assets such as stocks and exacerbating wealth-effect-driven inflation. The Fed should do so by letting its Treasury and mortgage securities run off. While it still makes sense to have ample reserves, it should target the lowest level wherever possible and only temporarily inject liquidity to address money-market volatility. Second, the Fed should use its regulatory capabilities to encourage AI-related borrowing through the banking system rather than the private credit ecosystem. Sceptics might argue it is better that the unknown risks of AI financing be kept outside the banking system, but this means the Fed is far less able to restrain lending when signs of froth emerge, as they have with the various multibillion-dollar circular financing arrangements that have come about in recent months. These AI deals are raising systemic risk, boosting asset prices and contributing to wealth effect-driven inflation. The Fed should raise the capital ratio for loans to private credit and encourage lending via more formal and regulated channels. Finally, and perhaps most importantly, Warsh needs to convince markets that the Fed “put” is far out of the money.

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