The pessimists are already talking about 3% inflation later this year if energy prices don’t retreat. Most likely, Federal Reserve monetary experimentation will inflict a new great inflation on the U.S., although this is much more likely to occur in the next business cycle rather than the current one. Before that, we’ll get the shock of an economic slowdown — or even recession — which will exert some pause. So many households are right to ask whether their main asset will insulate them from this shock whenever it occurs. The answer from economic science is no.
House prices perform best during the asset-price inflation phase of the monetary cycle. During that period, low or zero rates stimulate investors to search for yield, which many do, shedding their normal skepticism. The growth in irrationality across many marketplaces is why some economists describe set price inflation as a “disease.” Usually, the housing and commercial real estate markets become infected by this disease at some stage.
Real estate markets are certainly not shielded from irrational forces. “Speculative stories” about real estate flourish and quickly gain popularity — whether it’s the ever-growing housing shortage in metropolitan centers; illicit money pouring into the top end from all over the world and high prices rippling down to lower layers of the market; or bricks and mortar (and land), the ultimate safe haven when goods and services inflation ultimately accelerates.
That last story defies much economic experience to the contrary. By the time inflation shock emerges, home prices have already increased so much in real terms under asset-price inflation that they cannot keep up with goods and services inflation, and may even fall in nominal terms. One thinks of the tale of the gold price in the Paris black market during World War II: prices hit their peak just before the Germans entered the city in May 1940 and never returned.
Real estate is only a hedge against high inflation if it is bought early on in the preceding asset-price inflation period. We can generalize this lesson. The arrival of high inflation is an antidote to asset-price inflation. That is, if it has not already reached its late terminal stage when speculative temperatures are falling across an array of markets.
To understand how home prices in real terms behave under inflation shock we must realize how, in real terms, they are driven by expectations of future rents (actual, or as given to homeowners); the cost of capital; and the profit from carry trade. All of these drivers have been operating in the powerful asset-price inflation phase the U.S. and many foreign countries have been experiencing during recent years.
Together they have pushed up the S&P Case Shiller national home price index to almost 20% above its long-run trend (0.6% each year since 1998), having fallen slightly below at its trough in 2011, and having reached a peak 85% above in 2006.
Let’s take the drivers in turn.
Rents are rising in many metropolitan centers.
The cost of equity is low, judging by high underlying price earnings ratios in the stock markets. Investors suffering from interest income famine are willing to put a higher price on future earnings, whether in the form of house rents or corporate profits, than they would do under monetary stability.
Leveraged owners of real estate can earn a handsome profit between rental income and interest paid, especially taking account of steady erosion of loan principal by inflation and tax deductions.
The arrival of high inflation would change all these calculations.
Cost of equity would rise as markets feared the denouement of recession, and reckoned with the new burden on economic prosperity. Long-term interest rates would climb starkly in nominal terms. Their equivalent in real terms would be highly volatile and unpredictable, albeit at first low in real terms (inflation-adjusted), meaning that carry trade income for leveraged owners would become elusive.
None of this is to suggest that a high inflation shock is likely in the second quarter. A sustained period of much stronger demand growth across an array of goods, services and labor markets would most likely have to occur first, and could be seen as early as the next cyclical upturn.
An economic miracle could bring a reprieve from inflation. But much more likely, the infernal inflation machine of expanding budget deficits and Fed experimentation will ultimately mow down any resistance in its way.
Brendan Brown is an executive director and the chief economist of Mitsubishi UFJ Securities International.