What Every Investor Should Understand About Inflation
I've been hearing a lot of talk about inflation recently, including a lot of bad information. Is inflation good? That's a hard question to answer. Real estate investors want to know whether we're likely to see inflation in the near future and the impacts on our businesses.
It’s important to understand exactly how inflation affects the economy in order to make smart decisions. Here, I’m not looking to make predictions here—what’s important is understanding how inflation works and any associated pros and cons. Once you understand inflation’s mechanism, investors can make smart predictions and understand what’s going on and where things are headed.
What Is Inflation?
First, let’s define inflation. There are very formal and academic definitions, but I’m going to ignore those for now. In short, inflation is simply the increase in the prices of goods and services. When the same things cost more than they did previously, that’s inflation. And when they cost less, that’s deflation.
The United States's Bureau of Labor Statistics regularly calculates the inflation rate using a number of different measures, including the Consumer Price Index. (They actually have a pretty cool tool designed to compare prices between different years.) Recently, the Consumer Price Index rose 0.4 percent in August 2020—however, that doesn’t necessarily mean that inflation will rise, too.
And if it does? One big myth I want to dispel right off the bat is the idea that all inflation is bad. Obviously, there are aspects of inflation that negatively impact us—if it costs more to buy stuff, that reduces our purchasing power, essentially making us poorer relative to when things were cheaper. Our money doesn’t “go as far” as it used to.
Is Inflation Good? Here Are the Benefits
This isn’t necessarily a bad thing in all cases. First off: The Federal Reserve actually targets a specific inflation rate—two percent. So, clearly, moderate inflation is expected. In fact, zero inflation is bad. Here are other ways inflation can benefit you.
Inflation in the cost of goods and services usually comes with higher wages, too. As things go up in price, income goes up, too. If income keeps pace with inflation, things aren’t bad. It’s when income doesn’t keep pace with inflation (prices go up faster than wages) that we have an issue.
Second, inflation is important because it increases economic activity. While the price of things going up is bad for consumers, the price of things going down (or even staying the same) is bad for businesses. When business are selling things for less, this means less profit, less purchasing, less expansion, less growth.
The economy is just a reflection of business growth, so if businesses aren’t growing, the economy isn’t growing. Growth in the economy is directly related to inflation. And—at least according to those defining monetary policy—it’s more important for businesses to be growing than for consumers to be getting things for cheaper (and I agree).
Finally, there are some natural forces that usually keep in inflation in check. Forces that tend to lower prices. And there are things that the government/Fed can generally do to slow inflation if it starts to get out of control. So, runaway inflation usually isn’t an issue.
But the opposite isn’t necessarily true. It’s much harder to control deflation when it takes hold, and deflation can quickly start to snowball out of control once it starts. It’s better to have a bit more inflation than is desirable than to risk not having enough inflation and everything spiraling downward (“deflationary spiral”).
Long story short, the right amount of inflation is a good thing that will keep the economy humming along (growing) and keep things from spiraling downward.
The Fed’s Current Inflation Expectations
Historically (over the past decade), the Federal Reserve has targeted about two percent inflation per year. Meaning, price levels for goods and services should rise about two percent per year to make the Fed happy with our economic growth. To most consumers, that should feel like pretty stable prices.
Now, there is a lot of debate about what actual inflation is—some would say that the price of some essentials is increasing much higher than two percent these days. But the formal government measurements put annual inflation at between one and two percent for much of the past decade. In other words, lower than the Fed target.
There was an announcement by the Federal Reserve last week, essentially saying that the new inflation target is “average inflation of two percent” over time. Doesn’t sound much different than the old policy of “two percent inflation,” but it actually is. This new target means that after times where we run less than two percent inflation, the Fed will do things to try to get inflation above two percent, thus creating an average two percent inflation over time.
What inflation rate will the Fed target?
Well, if we assume that inflation leading up to 2020 has been less than two percent, and inflation during 2020 (due to the economic shutdown) will be much less than two percent—perhaps around 0.8 percent—that means that the Fed could target 2.5 percent, three percent, or even more over the next couple years. This is a huge departure from the two percent target the Fed previously set, and it means that we could see much higher inflation over the next couple years if the Fed gets its way (and they usually do).
Now, here’s a key point: While it’s not clear exactly how the Fed will achieve higher inflation, we can make an educated guess.
Typically, there are two ways to do this: lower interest rates (which encourages spending instead of saving and drives the economy) or printing money (which puts more money in the hands of consumers and drives the economy). With interest rates at zero percent, there isn’t much lowering that’s likely to happen short-term (whether we’re going to see negative rates is debatable, but I don’t think that will be an easy decision for the Fed).
So, that leaves printing more money. Let’s assume that this is the preferred method by which the Fed decides to increase inflation. How will that impact us as both consumers and real estate investors?
The Impact of Printing Money
Short-term, nobody has any idea where the market(s) are headed, but assuming we trust the Fed when they say they are targeting higher inflation and assuming we believe they will attempt to achieve this through stimulus and increased money supplies, we can draw some conclusions and takeaways.
Cash isn’t king
Inflation and increased monetary supply will likely lead to a reduction in the spending power of our currency. So, my first takeaway here is that holding cash long-term will probably eat away at your net worth. Not saying that keeping some cash is bad, but we probably won't want to be doing it as an investment strategy.
Interest rates remain low
There are some monetary theories that argue that with low enough interest rates, the federal government can print a ridiculous amount of money without concerns of default. There is reason to believe this is true, and the most obvious conclusion stemming from that is that the Fed will likely want to (have to) keep rates low for as long as our debt is increasing. Unless you think we’re somehow going to start paying down our debt, this likely means that interest rates could be low for a long time.
Real estate is a good hedge
The nice thing about owning real estate during an inflationary period is that hard asset values (the value of the properties) and rental rates will often keep pace with the broader inflation. If things cost twice as much, that cash you have in the bank is now worth half as much, but your real estate is likely going to be more and your rental income is likely to have increased.
Real estate (and other hard assets) tends to do well during inflationary periods.
…But debt will be the best hedge
The best hedge against inflation is debt. The reason being is that during an inflationary period, wages and income tend to rise. But your debt stays the same. If you are making $100,000 this year and have a $1,000 per month mortgage payment on your rental property, you are spending one percent of your income paying your debt service. But if due to inflation, you’re making $200,000 next year, that $1,000 per month mortgage payment won’t have changed. Your debt service is now 0.5 percent of your income!
If there’s enough inflation, you might earn enough to pay off your debt with a single paycheck. (Although obviously we don’t want that much inflation).
Risks Associated With Printing Money
Now, any time we’re talking about inflation and printing lots of money, there are some big risks—not just to us as investors but to the economy/currency overall. And I’d be remiss not at least touching on some of those risks.
Here are the big five that I see.
The biggest risk I see with the current situation is what is known as stagflation. That’s essentially an economic situation where we see inflation, but we don’t get the typical benefits of that inflation. Prices are increasing, but we don’t get economic growth to offset those increased prices.
It’s not well understood what causes stagflation. However, pushing inflation during times of economic turmoil may result in stagflation. If history is any indication, that can destroy an economy for decades.
The next potential risk is hyperinflation, which is simply runaway inflation. While two percent inflation might be good for the economy, 10 percent (or much more) can be devastating. Imagine a gallon of milk costing $50—that’s hyperinflation.
Much like deflation can spiral out of control, under the right conditions, so can inflation. If that hyperinflation is coupled with economic growth, there are things the Fed can do to slow the economy down and control that inflation. But if hyperinflation is a result of stagflation, things can get ugly—quickly.
I don’t see this as a huge risk short-term, but any time a central bank is printing a lot of money, it’s a risk.
3. Currency reset
The last time we saw a global currency reset was during WWII (do a search for “Bretton Woods”). Many of the largest economic superpowers banded together and defined new rules for rebuilding the international economy. Given the amount of worldwide debt among large nations, it’s not far-fetched to think we may be closing in on the point where this may need some sort of “reset” in currencies and a revision of international economic rules.
What would this look like? Where would it leave the U.S. in terms of economic superiority? How would it affect us as investors? Nobody knows, and that’s the scary part of this.
4. U.S. dollar at risk
The U.S. has the “reserve currency” of the world. The U.S. dollar is supreme, as it’s the most commonly used currency for international trade. There are big risks to printing money and increasing national debt. Those who buy our debt—like China—may lose faith in our ability (or willingness) to pay back interest.
When creditors start losing faith in borrowers, they start cashing in their debt and they stop lending. If China and Japan decide to stop buying our debt, that will impact interest rates and it will impact our entire economic strategy and future.
5. World’s reserve currency changes
The other risk to our currency is if other major economic superpowers around the world decide that they want to organize a massive coup against the U.S. dollar. If enough large nations with a big enough percentage of international trade decide that they want to start trading in some other currency, the U.S. dollar could quickly be overthrown as the world’s reserve currency.
Already, China and Russia have started to band together to trade without the U.S. dollar. If they can bring a few more major players into the fold to start using the Yuan or some other currency, the U.S. dollar could go away as the world’s reserve.
Whew! That’s a lot to get our heads around. And that’s only one part of the equation that will factor into what’s to come for the U.S. economy over the next several months, years, and perhaps decades.
If you want to learn more about how the economy works, how economic cycles work, and how they impact real estate investors, check out the BiggerPockets book Recession-Proof Real Estate: How to Survive (and Thrive) During Any Phase of the Economic Cycle.
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