Are We Ready for Inflation?
Everyone has talked about it. All of the intellectuals in the economic and financial community know that we desperately need it. Even people on Main Street understand that we need it, once they comprehend its effects on their paycheck. The “it” is obviously inflation, or as Webster’s would put it, the continuing rise in the general price level usually attributed to an increase in the volume of money and credit relative to available goods and services.
As much as the “rise in the general price level” sounds like sin to a person who just paid $4.25 for a gallon of gas, when they only paid $3.85 for the same gallon just three weeks ago at the same pump, the need for inflation is evident. Wages are stagnant like pond water and pay raises still sound a foreign language to most workers, accordingly, they are living on less, as prices of other goods and services march onward and upward. The idea of “inflated income” sounds wonderful to a worker living on minimum wages, a long overdue sign of appreciation to a middle manager or a taste of the holy grail for a top level manager. So depending on how one looks at it, inflation can be a very good thing.
Commensurately, interest rates normally rise with inflation. This has been the talk of the financial papers for all of 2014, and the bane of Janet Yellen’s existence since she became the Fed Chairwoman. “When is the Fed going to raise rates?” “Is the Fed going to get ahead of inflation or will they time it wrong?” “Has the Fed waited to late to put the brakes on the economy?” These are all fair questions to be asked because runaway prices can wreak havoc on an economy. If one thinks back to the late 70s/early 80s, memories of 17% mortgages and the sky-high prices for a “basket of goods” still runs deep in the mind. In those times, a near 20% interest rate combined with a strict debt to income or unbendable debt service coverage ratio requirement made qualifying for a real estate loan nearly impossible, as the high interest rates choked off affordability. However, with rates so low, a new phenomenon is occurring; prices of real estate assets have jumped so atmospherically high that returns are in the low single digits. This barely covers taxes, let alone inflation!
The one thing that inflation and higher interest rates did do during this time period was usher in an era of decent asset prices. If one could afford the payments, or if one could find a way to acquire properties with a seller carry back or some other form of creative financing, they could lock in on a property tax level that didn’t rival the payment of two BMWs. I admit higher interest rates are not fun, and the rates of today are the lowest in over 60 years, however, the purchase price of a property (and its commiserate tax level) is permanent, but its financing rate is not forever. Here in California, during the late 90s, rates were in the high 8s/low 9s. Homes in Redondo Beach sold in the $300,000s. Similar homes in similar areas now sell in the $900,000s with corresponding interest rates in the high low 4s. Which would you prefer, buying a home in the 300,000s at a temporary rate of 9% or buying a home at permanent price tag $900,000 with a temporary rate of 4%? As tempting as that 4% rate appears, the average homeowner only keeps a mortgage 6 years before they refinance. Accordingly, it makes sense to buy at a lower price as opposed to locking in a low rate, because it is tough to do both.
The drawback of reduced borrowing capacity is real with the advent of inflation. Whether mild or severe, a 1% rise in interest rate can reduce the average borrower’s purchasing power by 10-20%. Which is more than enough to wipe out many an American dream. Conversely, inflation severely tempers real estate prices as other asset types (stocks, bonds, mutual funds, etc.) start to offer more attractive (and more liquid) rates of return. A 6-unit, rent-controlled, multi-family building offering a 3% return on investment will get barely an offer at $1,100,000, but it will start to get looks once its price tag comes down to $500,000 or less.
At the end of the day, as bad as it sounds, we need inflation and higher rates to bring normalcy back to the market, as affordability in many parts of the country is unattainable for the average consumer. At an average rate of 1.5%, CDs and savings accounts are the laughing stocks of the financial industry. No one saves in an investment vehicle that has a rate of return lower than the rate of inflation. When JUMBO CDs begin to offer 5% and savings accounts get back to offering 3.5%, then we will see normal behavior. Then we will finally see workers being paid what they are worth and things will start to make economic sense. Until then artificially low rates in history and deflation will continue to foster fears of uncertainty. As crazy as it sounds, I don’t know about you, but I will trade in my financial uncertainty for a slightly higher and a little bit of inflation rate any time. How about you?
Preston Howard is a mortgage broker and Principal of Rose City Realty, Inc. in Pasadena, CA. Specializing in various facets of real estate finance; he can be reached at firstname.lastname@example.org.