Is the Fed’s inflation optimism justified – or are we in for a big correction?

For real estate investors, “transient” may be the most important term of 2021 – as the Federal Reserve manages the current U.S. inflation. I’m sure you’ve seen the headline: Depending on the criteria used, inflation, or the price of goods and services, the maximum in 10 years or 20 years … or more.

Either way, suffice it to say that inflation has been going on for the longest time.

The financial world has changed a lot since the last time inflation rose. Some would argue that we now have new tools and new philosophies that will allow us to protect ourselves from the dangers of the past. Theoretically, investors will enjoy extremely low interest rates and healthy economic expansion in the years to come.

Great. Hopefully that will happen. But inflation is not a disease we have cured. This is not a key point. It’s a phenomenon that has existed as long as money existed – and it will continue to exist. And it could have a tectonic-level impact on the housing market over the next few years.

With quantitative easing, trillions of dollars of stimulus and “emergency measures” and helicopter cash flowing 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 that we can expect a definite result from something that has never been tried before.

What you should know about the Federal Reserve Board today

Transit is not a term that was mentioned once when passing the Federal Reserve Board. This is a principle. Practically a new religion. Jerome Powell, chairman of the Federal Reserve Board, is the high priest of the new church in Transitary. He and 11 other voters on the Fed’s Open Market Committee have used the term “transient” in less than 150 years to describe our current inflation in 2021.

They don’t argue that there is inflation, you’re reading it right now. What they are trying to preach is – deep breath, the sermon becomes complicated here:

  1. The worst of this inflation is now, and will continue to rise for another month or two before quickly returning to a normal level that will be low enough to keep interest rates in the 10% treasury range from 2% to 3%. This is equivalent to keeping the mortgage rate in the range of 3% to 3.5%, where they have been hanging lately.
  2. Assuming the economy is strong, at some point in 2022, they could gradually raise short-term rates and start in 2 to 2 years. This will instead bring the entire yield curve closer to the “recent historical rules”. Translation: 4% to 5% rate over 10 years, resulting in 5% to 6% 30 year mortgage rate.

In this stylish situation, the housing markets will be cool but there will be enough time to absorb the high mortgage rate, while personal income will continue to rise with things like rent.

Why is this Federal Reserve sermon important? Because the Open Market Committee is the group that sets the short-term interest rate, which effectively indicates the overall yield and mortgage rate curve.

Let’s take a look at the recent inflation trends and the historical context so that we can see the current picture and background. This is an important framing for anyone who keeps a mortgage, looking to buy more property, or relying on cash flow from rent to maintain an investment portfolio.

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Economists use a number of metrics to assess the current state of inflation. I will try to be brief on this tour which many (most?) People consider, oh, only the most annoying thing is conceivable. I promise you: this is important.

The most quoted measure of inflation is the CPI, or Consumer Price Index. Basically, CPI looks at a large basket of products and services that people spend money on each month and notes how much each item has increased or decreased from the previous month. This is not 100% effective in taking precise vibrations of things – but then again, no inflation can be measured. The money I spend is different from what you or anyone else spends every month.

However, the CPI is fairly good at predicting when the tide is rising or falling. And the most worrying thing about inflation we see today is that it is rising high and fast.

For the month of June, the latest CPI report indicates that we have seen a monthly increase of 0.9% from 0.6% in May. The 5.4% annual growth is the highest since 2008 for the CPI and has surpassed past expectations of 4.9% growth.

In some historical contexts, the CPI has not run for more than 5% since 1990. Looking at this chart, I sympathize with those who think that inflation is a disease that we have somehow cured:

The Fed’s preferred measure

The Fed looks at CPI, but they actually have a preferred metric – personal spending, or PCE. The Fed policy states that they want to see a maximum of 2% on PCE for a fixed period before raising rates – and stops their monthly purchases of 120 120 billion in mortgage-backed securities, a big reason mortgage rates are so low at the moment.

As of June, the PCE was up 4.4% from a year earlier, well above the Fed’s target. Powell walked in front of Congress the day after the PCE print and said, “Inflation has risen significantly and will rise further in the months leading up to moderation.”

Oooookedokey. Hope he’s okay. But other Fed governors are already taking a break from the gospel and suggesting that inflation could last longer and that the Open Market Committee needs to raise rates and start buying MBS faster than planned.

So what does the actual information of the soil say?

Inflationary measures like CPI and PCE lag behind. It takes time for price upward pressure to build a chain from raw materials to production to the shelf (or Amazon listing).

Bloomberg Commodity Spot Index, which includes metals and agricultural products – the things that go In The things that everyone buys – have increased by 50% year after year and by about 15% in 2021.

And the producer price index, or PPI, which measures prices at the producer or manufacturing level, rose 1% in June, up from 0.8% in May. The 1% increase was only against the consensus expectation of 0.5%. These numbers may seem small to look at, but in the language of economics that is a very big miss in contrast to the large minority. Year after year, the PPI continues to grow at 7.8%, the fastest pace in more than a decade.

Let me tell you what never happens in corporate finance: a situation where companies see rising costs and No. Pass these increased costs on to final consumers. Especially when the economy is strong! We should expect that every point of PPI rise will appear in the CPI in the coming months.

The Fed is eight-ball behind here. Data is the opposite of what they are and they are taking the time they borrow to promote what people see with their own eyes. I think the Fed knows it personally, but for the rest of 2021 it needs to do a wide, well-speeded backpiding.

Risk of policy mistakes

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 tackle inflation by raising interest rates.

If a policy mistake is made by waiting too long, a major setback can occur in the housing market. For example, if the Fed is forced to raise rates by 1% (or more!) Within a month, the effects will be severe. The Origin promoter will be frozen in the crowd of applications trying to get under the wire. Deal flow will be slower than the speed of snails. The affordable rate for home buyers will be 80% to 90% to 40% to 50%. In this situation, the average selling price will probably go down – and they will, at the very least, stop the clip that has been rising over the last few years.

Treasury markets may make additional corrections out of fear as investors flood with sell-offs in the bond market, causing the current rate to be higher than what the CPI is running or the Fed is trying to show us the way. This could endanger the entire economy. And for those who were entering the extra dose, it would be a major, major buzz.

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Impact for the real estate market

There is some mystery as to why the current rate is so low even today, because inflation is going on, not jogging, exceeding everyone’s expectations for the year. Most of the mystery can be solved through the relentless propaganda of Powell and other Fed governors. But they are already squeezing their hands ahead of their deadline to start raising rates.

Economics is a very slow science. But things in the Fed can move fast, just talk about something and put it in motion. Financial markets take pride in seeing which way the wind blows and sees a quick response. If “transient” is a desire, not a reality, conventional treasury (and after all, mortgage) rates can rise rapidly, moving at a rate of two percentage points or more in a few months.

I understand why most investors under the age of 30 have little fear of rising mortgage rates or declining property values. They just haven’t seen it in their investment lifetime. Those of us who have enough gray hair have noticed that they can talk to the brick-to-head effect.

By no means do I want to convey that I recommend for the mother to be inactive. Investing is a lifelong journey, and the best investors can not only navigate but make hay when the markets are up, down, flat and everything in between. But the best investors are playing chess – and in chess, sometimes you have to play defense. And if you don’t have the idea of ​​the whole board, you don’t know how to attack or defend.

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