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Is the Fed’s Inflation Optimism Justified—Or Are We in For a Big Correction?

Ryan Barnes
6 min read
Is the Fed’s Inflation Optimism Justified—Or Are We in For a Big Correction?

For real estate investors, “transitory” may be 2021’s most important word—because it’s how the folks who run the Federal Reserve describe the United States’s current bout of inflation. I’m sure you’ve seen the headlines: Depending on the measuring stick 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.

Either way, suffice to say inflation is running the hottest it’s been in a very long time.

A lot has changed in the financial world since the last time inflation spiked like this. Some would argue that we have new tools and new philosophies in place now, which will allow us to skirt past near-term danger. Theoretically, investors will enjoy ultra-low interest rates and healthy economic expansion for years to come.

Awesome. Hope that happens. But inflation is not a disease we’ve cured. It’s not a moot point. It’s a phenomenon that has existed for as long as money has existed—and it will continue to exist. And it could have tectonic-level effects on the housing market in the next few years.

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 succession. It would be foolish and arrogant to assume we can anticipate a precise outcome from something that’s never been tried before.

What you should know about today’s Federal Reserve Board

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

They don’t debate that inflation exists, right now as you read this. What they’re trying to preach is—deep breath, the sermon gets intricate here:

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

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

Why does this Federal Reserve sermon matter? Because the Open Market Committee is the group who sets short-term interest rates, which effectively dictate the trajectory of the entire yield and mortgage rate curve.

Let’s take a glance at the most recent inflation trends as well as the historical context so we can see the current picture and the backdrop. It’s an important framing for anyone who holds a mortgage, is seeking to buy more properties, or relies on cash flow from rentals to sustain an investment portfolio.

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The current picture

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 topic imaginable. I promise you: It’s important..

The most 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 every item went up or down in price from the month before. It’s not 100% effective at taking the precise pulse of things—but then again, no inflation measure can be. What I spend money on is different from what you or anyone else spends money on month-to-month.

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

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

For some historical context, the CPI has not finished a year running over 5% since 1990. Looking at this chart, I empathize with those who think that inflation is a disease that we’ve somehow cured:

fred 1

The Fed’s preferred measure

The Fed looks at the CPI, but they actually have a preferred metric—the Personal Consumption Expenditures, or PCE. The Fed policy states that they want to see, at most, 2% on the PCE for a sustained period of time before they raise rates—and cease their monthly purchase of $120 billion in mortgage-backed securities, a major reason mortgage rates right now are so low.

As of June, the PCE was running a 3.4% increase over the past year, well above the Fed’s target. Powell went right out before Congress the day after that PCE print and said, “Inflation has increased notably and will likely remain elevated in coming months before moderating.”

Oooookedokey. Hope he’s right. But other Fed governors are already breaking from the gospel and suggesting that inflation may run hotter for longer, and that the Open Market Committee needs to start raising rates and cutting MBS purchases faster than planned.

So what does the actual data on the ground say?

Inflation measures like the CPI and the PCE are backward-looking. It takes time for upward price pressures to make it up the chain from raw materials to manufacturing to the shelf (or Amazon listing).

The Bloomberg Commodity Spot Index, which includes metals and agricultural commodities—i.e. the stuff that goes into the stuff that everybody buys—is up 50% year-over-year, and about 15% in 2021 thus far.

And the Producer Price Index, or PPI, which measures prices at the producer or manufacturing level, rose 1% in June, up from a 0.8% climb in May. The 1% rise was against a consensus expectation of just 0.5%. These numbers may look small, but in economics parlance that is a very large miss versus the consensus. Year-over-year, the PPI is clocking in at 7.8% growth, the fastest pace in more than a decade.

I’ll tell you what never, ever happens in corporate finance: A situation where companies see costs go up and don’t pass those increased costs on to final consumers. Especially when the economy is strong! We should expect to see every point of that PPI rise show up in the CPI in the months ahead.

The Fed is quite simply behind the eight-ball here. They’re running 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 broad, well-paced backpedaling over the remainder of 2021.

The risks of a policy mistake

Many important economists and former central bankers are sounding alarm bells for what could happen if the Federal Reserve—and other central banks around the world—wait too long to combat inflation by raising interest rates.

If a policy mistake is made by waiting too long, there could be big disruptions to the housing market. For example, if the Fed is forced to raise rates 1% (or more!) within a month, the ripple effects would be fierce. Loan originators would freeze out amid a rush of applications trying to get in under the wire. Deal flow would slow to a snail’s pace. Affordability rates for homebuyers would go from 80% to 90% to 40% to 50%. In this scenario, average selling prices would probably drop—and they would, at minimum, stop rising at the clip they have been the past few years.

The treasury markets could over-correct out of fear as investors flood the bond market with selling, leading to prevailing rates higher than what either the CPI is running or the Fed is trying to guide us to. This could endanger the entire economy. And for folks who were overleveraged going in, it would be a major, major buzzkill.

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Implications for real estate markets

There’s a bit of mystery as to why prevailing rates are still so low today, given that inflation is running, not jogging, past everyone’s expectations coming into the year. Most of the mystery can be solved by the unending preaching from Powell and other Fed governors. But they’ve already tipped their hands by pulling forward their timeline to start raising rates.

Economics is a pretty slow science. But things can move really fast between the Fed just talking about something and setting it in motion. Financial markets pride themselves on seeing which way the wind blows and reacting quickly. If “transitory” is a wish, not a reality, prevailing treasury (and, soon thereafter, mortgage) rates could rise fast, moving two percentage points or more in a matter of months.

I can understand why most investors under 30 have little fear about mortgage rates rising or property values falling. They simply haven’t seen it in their investing lifetimes. Those of us who have enough gray hairs to have witnessed it can speak to the brick-to-the-head effect these things can have on one’s investing plans.

By no means am I suggesting to scrap plans or run for the hills. Investing is a lifetime journey, and the best investors can not only navigate but make hay when markets are up, down, flat, and everything between. But the best investors are playing chess—and in chess, sometimes you have to play defense. And you can’t know whether to attack or defend unless you have a sense of the whole board.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.