If you’re reading economic news or watching CNBC these days, you’ve almost certainly heard the “i” word thrown around. Economists of all stripes, policymakers, and talking heads are debating the potential for inflation and the risks associated with it. Given the negative potential harm that inflation could have on housing, it’s worth exploring this issue a bit further. Today, I want to outline a few things. First, what it is and why people are concerned. Second, what factors are sparking this concern. And finally, why some economists aren’t concerned at all.
In simple terms, inflation means real prices for goods and services are rising. This is usually triggered by increases in demand. As more people purchase given goods and services, providers tend to raise prices to keep up with the cost increases associated — that’s simple supply and demand. At the same time, if wages don’t rise at the same pace as the cost of goods and services, actual buying power decreases for consumers. If people can afford to buy less, demand drops, and you could find yourself in a recession. Given that prices change much more rapidly than wages, this is a real risk.
To control inflation, the Federal Reserve, whose mandate requires doing so, tends to raise interest rates. This tactic reduces the monetary supply and taps the brakes on the economy, so it doesn’t overheat. Needless to say, if mortgage interest rates rise fast enough or far enough, the housing industry would be challenged. It would substantially impact what people can afford, and given the limits on supply and how fast prices have risen in many markets, you’d see a sharp drop in qualified buyers. It should be noted that the FED raising rates isn’t directly tied to mortgage rates, but the two are correlated in some ways.
Three main factors are behind this newly intense focus. First, as vaccinations continue at a strong pace, the general expectation is that a more normal world is within sight, leading to increased consumer spending. The second factor is another COVID-19 relief bill that just passed through Congress with a price tag of $1.9 trillion meant to help bridge the gap until that moment. The third factor is an infrastructure package now being debated, which could have a similar price tag. All of this is likely to increase economic activity, and thus demand. Oddly enough, inflation concerns can often be a self-fulfilling prophecy. It’s possible if vendors believe inflation is coming, they will just begin to raise prices to stay ahead of it.
It’s easy to read the last few paragraphs and come to the conclusion that we’re heading for a problem. A few years ago, when President Trump was considering a nearly $2 trillion dollar tax cut (which was enacted) and an infrastructure package (which never materialized), people raised similar concerns, myself included in an early 2017 analysis. In fact, economists have periodically warned about inflation many times over the last several decades. However, nothing has occurred. That’s why some economists aren’t showing much concern.
In fairness, it’s puzzling in that it runs counter to basic economic teaching, yet even the world’s leading economic thinkers aren’t entirely sure why expected inflationary risks haven’t materialized. There are several hypotheses for what is happening.
The first is that our current measures of economic vitality, which typically include GDP and the unemployment rate, fail to accurately tell us how much untapped potential (slack) there really is in the economy. Because the unemployment rate only factors in people actively looking for work, a 5% unemployment rate could mask a 10% real unemployment rate. Thus, as the conditions that would likely lead to inflation occur, it doesn’t happen because there is more than enough “slack” in the economy to absorb added stimulus, given that we aren’t really in a maximum output environment.
Another possible explanation is that the distribution of gains has reached a point of inequality such that the impacts of stimulative measures aren’t felt as wildly. Put more simply, inflation is driven by an excess of demand. However, as many people are struggling to meet basic needs, and often go into debt to do so, these stimulative measures are helping people rebalance how they finance their needs (cash versus debt) and increase their savings rates.
All of this is to say that, while inflation could cause real problems, economists' predictions have been consistently wrong on this for the last few decades for reasons that aren’t entirely clear. While this isn’t to say that those who are concerned about inflation will be wrong this time, it’s possible that there is something structurally in the economy — whether it be technology, inequality, an imprecise reading of capacity, or some other yet to be identified item — that is offsetting these various stimulative measures.
Regardless, it remains unlikely that we will see any meaningful impact on housing in 2021. The infrastructure bill or bills, should they even pass, won’t pass for months and won’t result in much added spending in 2021. There remains enough uncertainty around the pandemic, including enough vaccine hesitancy plus a new surge in cases, that the runaway energy of the economy’s potential will likely be naturally constrained. While I may regret putting this in writing in a few months, I think the real test will come in 2022. We may find that the normal laws of economics still apply, or we may witness massive expansion without any impactful inflation.