What is Inflation?
According to the linked June 10, 2021, Washington Post article, inflation jumped 5 percent in the past year, the fastest pace in 13 years. Few are panicking yet, but there’s a big debate about how long prices will stay high. So, what exactly is inflation and how does it affect you?
Inflation is a sustained and generally felt increase in prices. I am going to cover two types of inflation that the US economy is facing in 2021:
1. Demand Pull inflation occurs when too much money is chasing too few goods. The Utah housing market is experiencing this right now as there are many more home buyers in the market than there are homes for sale; as a result, prices have risen dramatically over the past 3 years.
As the US economy entered the March 2020 shutdown, prices on many goods began to fall due to lack of demand; hotels could not fill their rooms, so they lowered their nightly room rates and this process replicated itself throughout the global economy. As the economy began to reboot and businesses reopened their doors, demand began to slowly pick up, but global supply chains were still in disarray with raw goods left stranded in countries around the world without available labor, and significant shipping delays. Even if the supply could keep up with the demand, the logistics built upon “just in time inventory management” would not have afforded for the increase in demand over such a short period of time.
Ultimately, when demand exceeds supply, a shortage results and price increases. When shortage is extinguished quickly, prices will fall back into their established trend. However, this time is a little different due to the pandemic relief payments issued by the government – which have added fuel to the demand fire. Now that these payments have stopped, it could take the trillions of dollars of money that has flooded the economy a year or two to settle.
Another factor that must be considered is that the Federal Reserve has kept rates at historic lows which encourages purchase on credit. Eventually they will be required to raise rates which will mean that borrowing money will be more expensive and demand will be stifled.
2. Cost Push Inflation is a general rise in prices caused by an increase in the cost of production. This type of inflation is seen in increased prices of commodities such as oil, gold, corn, wheat, cotton, or lumber. The longer it takes for prices to stabilize, the more the cost of production will be pushed down to the consumer.
The Utah housing market is also experiencing this type of inflation right now as the cost of lumber, glass, cement, and other building materials have risen to the point where the “just in time inventory management” that builders use has been thrown into disarray and costs have been pushed up at a blistering pace.
How Does the Federal Reserve Combat Inflation?
The Federal Reserve aims to keep the rate of inflation at a moderate 2% to encourage economic growth because when consumers expect a rise in overall pricing, they continue to spend now rather than putting off purchases. This stimulates the economy to keep money moving and encourages production job growth, and less unemployment. When inflation begins to rise above this level it becomes more difficult for businesses to set pricing on their goods and for consumers to plan for their spending.
Historically, when long-term inflation begins to rise above 2%, the Federal Reserve has increased the Prime Rate which represents the credit rate that banks extend to borrowers for consumer loans. Ultimately raising the Prime Rate decreases the price of bonds which negatively impacts fixed-income investors. As rates rise, people are also less likely to borrow or re-finance existing debts, because it is more expensive to do so. The theory behind this is to slow growth and stabilize the economy by discouraging short term borrowing (credit cards, home equity lines, auto loans, and personal lines of credit) and to encourage longer term investments.
How Does Inflation Affect Interest Rates?
What does inflation and increased rates mean for real estate? Let’s explore the inflation cycle as it relates to housing and real estate.
Inflation makes the dollar and your purchasing power less valuable. A simple example (the math is actually a little less than in this example) would be to assume that by using the 5% increase in inflation over the past year (mentioned in the Wall Street Journal above), if you purchased an ice cream cone in 2020 and it cost you $1.00, in 2021, that same ice cream cone would cost you $1.05.
The dollar loses value to purchase products imported by other countries including products such as oil that are traded in dollars globally.
Investors and Wall Street begin to sell off bonds tied to mortgages (mortgage-backed securities) because they do not want an investment that is likely to lose value over time. In turn, this increases the supply of bonds to the market thus lowering their value for long term investments.
As the bond prices fall, the mortgage bond yields rise – which are the basis of mortgage rates.
Rising mortgage rates increase inflationary pressure on the economy.
How Does Inflation Affect Real Estate?
With this knowledge, you can see that by just keeping your money in the bank, your money is actually losing value. So, how can investing in real estate help you to maintain or increase your wealth? Investing in real estate is dependent on the specific market and location of the property it resides in. Generally, real estate investments see greater gains in an inflationary economy. I have several clients that have begun to “bank cash” into rental properties as they can take advantage of appreciation of the property and have a plan to combat increased costs by adjusting their rent to meet or exceed those increases and continue receiving the return on their money.
The current market is exceptional for real estate as mortgage interest rates remain at all-time lows and the demand for housing is at all-time highs which has allowed exceptional appreciation for property values. This increase in real estate property values has gone up at a much higher percentage than the decrease in value that is being seen to the dollar due to inflation. As an investor in real estate, if you borrow money before the onset of inflation occurs, you will benefit from a lower valued dollar because you will still owe the same amount of money to the lender of your property, but as wages rise to offset increased costs due to inflation, means less is going to housing to pay off your debt and the more can go to other investments, food, travel, and fun.
Once interest rates on mortgages begin to rise, we will see three results in the market
Buyers will not be able to afford as much, and many will be forced out of the market and look to rent.
Rental rates will increase which is good for investors of rental properties.
Housing prices will begin to stabilize, and a pricing correction will occur.
Final Thoughts
You probably know that real estate has long been the playground for the rich and well connected, and it’s also been the best performing investment in modern history. But, because of low interest rates those barriers have come crashing down - and now it’s possible to build REAL wealth through real estate at a fraction of what it used to cost, meaning the unfair advantages are now available to individuals like you.
If you own a home or are an investor in real estate and own rental properties, you will benefit from inflation as you can have a stable asset to protect your wealth as property values go up and rental prices also go up. If you only have money in the bank, then everything you have possession of is going down in value as the buying power of the dollar decreases. Now is the time to act – there are still fantastic opportunities available, and I can certainly help you to find them.
I would love to speak to you about anything real estate, please contact me at brandonrwood19@gmail.com or 801-885-2558.