For real estate investors, “temporary” may be the most important word for 2021 – this is how the heads of the Federal Reserve describe the current surge in inflation in the US. You probably know the headlines: Depending on the yardstick used, inflation or a broad spike in the prices of goods and services is either the highest in 10 years or 20 years … or even more.
Anyway, suffice it to say that inflation is hotter than it has been in a long time.
Much has changed in the financial world since inflation last shot up like this. Some would argue that we now have new tools and new philosophies that will enable us to bypass short-term dangers. In theory, investors will benefit from extremely low interest rates and healthy economic expansion in the years to come.
Brilliant. Hope this happens. But inflation is not a disease that we have cured. It’s not a moot point. It’s a phenomenon that has existed since money was around – and it will continue to exist. And it could have tectonic effects on the housing market in the next few years.
Between quantitative easing, trillions of dollars in stimulus and “emergency response,” and helicopter dropping cash straight into people’s hands, we’ve done many things that we’ve never done before – certainly not one at a time. It would be foolish and arrogant to assume that we can foresee an exact result from something that has never been tried before.
What You Should Know About Today’s Federal Reserve Board
Temporary is not a word that the Federal Reserve Board once casually mentioned. It’s an ethos. Practically a new religion. The chief pastor in this new Church of Transition is Jerome Powell, chairman of the Federal Reserve Board. He and the other 11 voting members of the Fed’s Open Market Committee used the word “temporary” no less than 150 times to describe our current inflation rate in 2021.
You are not discussing that inflation exists right now as you read this. What they are trying to preach is – take a deep breath, the sermon gets complicated here:
- The worst of that inflation is here right now, and will only continue to rise for a month or two before quickly falling back to normalized levels that will be low enough to keep 10-year government bond rates in the 2% to 3% range . This would mean keeping mortgage rates in the 3% to 3.5% range where they have been hanging around lately.
- Assuming the economy remains solid, from 2022 they can begin gradually raising short-term rates over 2 to 3 years. That, in turn, will raise the entire yield curve to a level close to the “latest historical norms”. Translation: 4% to 5% interest over 10 years, resulting in 5% to 6% 30 year mortgage interest.
In this idyllic scenario, real estate markets would cool down but would have time to absorb higher mortgage rates while personal income rose steadily along with items like rents.
Why is this sermon important to the Federal Reserve? Because the Open Market Committee is the group that sets the short-term interest rates that effectively determine the course of the entire interest and mortgage yield curve.
Let’s take a look at recent inflation trends as well as the historical context so we can see the current picture and background. It’s an important framework for anyone with a mortgage, looking to buy more property, or relying on rental cash flow to sustain an investment portfolio.
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The current picture
There are several metrics that economists use to assess the current level of inflation. On this tour I will try to keep myself short of what many (most?) People consider to be the most boring topic one can think of. I promise you: it is important …
The most commonly cited measure of inflation is the CPI, or consumer price index. In essence, the CPI looks at a large basket of goods and services that people spend money on each month and how much each item has increased or decreased compared to the previous month. It is not 100% effective to get the exact pulse of things – but on the other hand, it cannot be a measure of inflation. What I spend money on differs from what you or others spend money on from month to month.
However, the CPI tells us fairly efficiently whether the overall tide is rising or falling and at what rate. And the most worrying thing about the inflation we are experiencing today is that it is both high and rising rapidly.
For June, the latest CPI report shows a monthly increase of 0.9% compared to 0.6% in May. The 5.4% yoy increase was the highest for the CPI since 2008, beating expectations of a 4.9% increase.
In a historical context, the CPI has not closed a year with more than 5% since 1990. Looking at this chart, I can empathize with those who think inflation is a disease we somehow cured:
The Fed’s preferred action
The Fed is looking at the CPI, but it actually has one preferred metric – personal consumption expenditure, or PCE. Fed policy is that they want to see no more than 2% of the PCE for an extended period of time before hitting rates – and stopping their $ 120 billion monthly mortgage-backed securities purchase, a major driver of mortgage rates right now are so small.
In June, the PCE was up 3.4% yoy, well above the Fed’s target. Powell stepped out of Congress the day after that PCE pressurized, saying, “Inflation has risen significantly and is likely to stay high for the months ahead before it slows down.”
Oooookedokey. Hope he’s right. But other Fed governors are already breaking the gospel, suggesting that inflation could get hotter for longer and that the Open Market Committee needs to start raising rates and cutting MBS purchases faster than planned.
What does the actual data say on site?
Measures of inflation such as the CPI and PCE are pointing backwards. It takes time for the upward pressure on prices to create the chain from raw materials through production to the shelf (or Amazon listing).
The Bloomberg Commodity Spot Index, which includes metals and agricultural commodities – the stuff that works in the stuff everyone buys – up 50% year-over-year and about 15% so far in 2021.
And the producer price index (PPI), which measures prices at the producer or manufacturing level, rose 1% in June, up from a 0.8% increase in May. The 1% increase was in line with a consensus expectation of just 0.5%. These numbers may seem small, but in economic parlance this is a very big mistake from consensus. Year-over-year, the PPI grew 7.8%, the fastest growth in more than a decade.
I’ll tell you what never happens in corporate finance: a situation in which companies see that costs rise and costs Not pass these increased costs on to the end user. Especially when the economy is strong! We should expect every point of that PPI surge to become visible in the CPI in the coming months.
The Fed is quite simply behind the figure eight here. They run on borrowed time to preach what data contradicts and what people see with their own eyes. I think the Fed knows this privately, but needs to orchestrate a broad, swift withdrawal for the rest of 2021.
The risks of political error
Many eminent economists and former central bankers are sounding the alarm 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 political mistake is made by waiting too long, it could cause major disruption to the property market. For example, if the Fed is forced to hike rates by 1% (or more!) Within a month, the impact would be severe. Lenders would freeze amid a spate of applications trying to get under the covers. The deal flow would slow down at a snail’s pace. The affordability rates for homebuyers would increase from 80% to 90% to 40% to 50%. In that scenario, average sales prices would likely go down – and at least stop rising as fast as they have been in recent years.
Treasury markets could over-correct in fear as investors flood the bond market with selling, resulting in prevailing interest rates higher than what either the CPI or the Fed is trying to guide us. This could endanger the entire economy. And for people who were over-indebted, it would be a big, big buzzkill.
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Effects on the real estate markets
It’s a little mysterious why prevailing interest rates are still so low today, with inflation exceeding everyone’s expectations for the year and not jogging. Most of the mystery can be solved through the endless sermons of Powell and other Fed governors. But they have already tilted their hands in moving forward their schedule to start raising interest rates.
Economics is a pretty slow science. But things can move very quickly if the Fed just talks about something and gets it moving. Financial markets pride themselves on seeing which way the wind is blowing and react quickly. If “temporary” is a wish rather than a reality, prevailing government bond (and shortly thereafter, mortgage) interest rates could rise rapidly and move two percentage points or more within a few months.
I can understand why most investors under 30 have little fear of rising mortgage rates or falling property values. They just haven’t seen it in their investment life. Those of us who have enough gray hair to witness can speak of the direct impact these things can have on investment plans.
In no case do I suggest abandoning plans or running into the mountains. Investing is a lifelong journey, and in addition to navigating, the best investors can make hay when markets are rising, falling, flat, and everything in between. But the best investors play chess – and in chess you sometimes have to play defense. And you can’t know whether to attack or defend if you don’t have a grasp of the entire board.