Is the Fed’s inflation optimism justified – or are we in for a major correction?

For real estate investors, “transient” may be the most important word for 2021 because it’s how the people who run the Federal Reserve describe the United States’ current inflation rate. I’m sure you’ve seen the headlines: Depending on the yardstick used, inflation or a broad rise in prices for goods and services is either the highest in 10 years or 20 years… or even more.

Anyway, suffice it to say that inflation is the highest in a very long time.

Much has changed in the financial world since the last time inflation soared. Some would argue that we now have new tools and new philosophies that allow us to circumvent the danger in the short term. Theoretically, investors will enjoy ultra-low interest rates and healthy economic expansion in the coming years.

Awesome. Hope that happens. But inflation is not a disease that we have cured. It’s not a moot point. It is a phenomenon that has been around as long as money has existed – and it will continue to exist. And it could have tectonic effects on the housing market for years to come.

Between quantitative easing, trillions of dollars in stimulus and “emergency measures” and helicopter drops of cash directly into people’s hands, we’ve done a lot of things we’ve never done before — certainly not in a row. It would be foolish and arrogant to assume that we can expect a precise outcome from something that has never been attempted before.

What you need to know about the Federal Reserve Board today

Temporary isn’t a word the Federal Reserve Board has mentioned once in a while. It’s an ethos. Pretty much a new religion. The head pastor in this new Church of the Transitory is Jerome Powell, the chairman of the Federal Reserve Board. He and the other 11 voting members of the Fed’s Open Market Committee have used the word “transient” no less than 150 times in 2021 to describe our current inflation.

They are not arguing about the existence of inflation as you read this. What they’re trying to preach is take a deep breath, the sermon gets complicated here:

  1. The worst of this inflation is now here and will only continue to rise for another month or two before quickly returning to a normalized level that will be low enough to keep 10-year Treasury interest rates in the 2% to 3% range. to keep. This would equate to keeping mortgage rates in the 3% to 3.5% range, where they’ve been hanging out lately.
  2. Assuming the economy remains solid, they can start gradually raising short-term interest rates over a period of 2 to 3 years from 2022 onwards. That, in turn, will push the entire yield curve up to levels close to “recent historical norms.” Translation: 4% to 5% interest on the 10-year, resulting in 5% to 6% 30-year mortgage interest.

In this idyllic scenario, housing markets would cool but have ample time to absorb higher mortgage rates, while personal incomes rose steadily, along with things like rents.

Why is this Federal Reserve Sermon Important? Because the Open Market Committee is the group that sets the short-term interest rate, which basically dictates the trajectory of the entire interest and mortgage yield curve.

Let’s take a look at the most recent inflation trends and historical context so we can see the current picture and background. It’s an important framework for anyone who has a mortgage, wants to buy more real estate, or depends on cash flow from rentals to maintain an investment portfolio.


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The current photo

There are several metrics that economists use to assess the current state of inflation. I’ll try to be brief on this tour through what many (most?) people consider, oh, just about the most boring subject imaginable. I promise you it’s important…

The most commonly cited measure of inflation is the CPI, or consumer price index. Essentially, the CPI looks at a large basket of goods and services that people spend money on each month and notes how much each item has increased or decreased in price from the previous month. It’s not 100% effective at taking the precise pulse of things, but again, no measure of inflation can be. What I spend money on is different than what you or someone else spends money on every month.

However, the CPI is fairly efficient at telling us whether the general tide is rising or falling and at what rate. And what’s most concerning about the inflation we’re seeing today is that it’s both high and rising rapidly.

For the month of June, the most recent CPI report indicates that we saw a monthly increase of 0.9%, up from 0.6% in May. The year-on-year increase of 5.4% was the highest for the CPI since 2008, surpassing expectations of a 4.9% increase.

For some historical contexts, the CPI has not gone by more than 5% since 1990. Looking at this chart, I sympathize with those who think inflation is a disease that we somehow cured:

The Fed’s Preferred Measure

The Fed looks at the CPI, but they actually have a preferred measure: personal consumption expenditure or PCE. The Fed’s policy says they want to see up to 2% on the PCE for a sustained period of time before raising interest rates — and stop their monthly purchase of $120 billion in mortgage-backed securities, a key reason why mortgage rates are now are so low.

In June, the PCE was up 3.4% over the past year, well above the Fed’s target. Powell went straight to Congress the day after that PCE printout, saying, “Inflation has increased significantly and is likely to remain high for months to come before it moderates.”

Oooookedokey. Hope he’s right. But other Fed governors are already breaking with the gospel, suggesting that inflation could rise for longer and that the Open Market Committee should raise interest rates and cut MBS purchases faster than planned.

So what does the actual data on the ground say?

Inflation measures such as the CPI and the PCE are retrospective. It takes time for upward price pressure to make the chain from raw materials to production to the shelf (or Amazon listing).

The Bloomberg Commodity Spot Index, which includes metals and agricultural commodities – that is, the things that go in the stuff everyone buys – is up 50% year-over-year so far and about 15% in 2021.

And the Producer Price Index, or PPI, which measures prices at the producer or production level, rose 1% in June, up from 0.8% in May. The 1% increase was against a consensus expectation of just 0.5%. These numbers may look small, but in economic parlance, that’s a very big mistake from the consensus. Year-over-year, the PPI clocked in at 7.8% growth, the fastest pace in more than a decade.

I’ll tell you what never, never happens in corporate finance: a situation where companies see costs rise and rise do not who pass on higher costs to the final consumers. Especially if the economy is strong! We should see every point of that PPI increase appear in the CPI in the coming months.

The Fed is simply behind the eight-ball here. They run on borrowed time to keep preaching what data contradicts and what people see with their own eyes. I think the Fed knows this privately, but will have to orchestrate a wide, quick kickback for the rest of 2021.

The risks of a policy error

Many major economists and former central bankers are sounding the alarms about what could happen if the Federal Reserve — and other central banks around the world — wait too long to fight inflation by raising interest rates.

If a policy mistake is made by waiting too long, major disruptions in the housing market can arise. For example, if the Fed is forced to raise interest rates by 1% (or more!) within a month, the ripple effects would be severe. Lenders would freeze amid a flood of applications trying to get under the wire. The deal flow would slow down to a snail’s pace. Affordability rates for home buyers would go from 80% to 90% to 40% to 50%. In this scenario, average selling prices would likely fall — and at the very least, stop rising at the levels of past years.

The government bond markets could correct too much for fear as investors flood the bond market with sales, leading to prevailing rates that are higher than what the CPI is charging or the Fed is trying to lead us. This could put the entire economy at risk. And for people overloaded to get in, it would be a big, big buzzkill.


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Implications for real estate markets

It’s a bit mysterious why prevailing rates are still so low today, as inflation is running, not jogging, past everyone’s expectations going into the year. Most of the mystery can be solved by the endless preaching of Powell and other Fed governors. But they’ve already tipped off by pulling their timeline forward to raise rates.

Economics is a pretty slow science. But things can move very quickly between the Fed just talking about something and getting it started. Financial markets pride themselves on seeing which direction the wind is blowing and reacting quickly. If “transient” is a wish and not a reality, current Treasury rates (and shortly thereafter mortgage rates) could rise rapidly, rising two percentage points or more in a matter of months.

I can understand why most investors under 30 are not afraid of rising mortgage rates or falling property values. They just haven’t seen it in their lives as an investment. Those of us who have enough gray hair to have experienced it can speak of the brick-on-the-head effect these things can have on one’s investment plans.

I’m in no way suggesting scrapping plans or running for the hills. Investing is a lifelong journey, and the best investors can not only navigate, but also make money when markets are up, down, flat and everything in between. But the best investors play chess – and in chess you sometimes have to defend. And you can’t know whether to attack or defend unless you understand the whole board.

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