Inflation investigation

Quick takes:

• Inflation remains elevated
• Demand growth outpacing supply growth
• Expected ease over time
• But inflation should remain elevated versus last cycle
• CRE positioned well for such an environment

Data released last week showed that inflation remained elevated, hitting levels unseen in decades, across various metrics. The headline consumer price index (CPI) for October increased 0.9% month-over-month, pushing the year-over-year rate to 6.2%, the strongest rate since November 1990. Meanwhile, the core CPI grew by 0.6% month-over-month, driving the year-over-year change to 4.6%, the largest rate since August 1991. Meanwhile, the headline producer price index (PPI) final demand for October grew 0.6% month-over-month, keeping the year-over-year rate at 8.6%, a record for this data series. 

What is happening?

The explanation for this inflation remains the same. Aggregate demand (AD) in the economy, boosted by government stimulus, low interest rates, and the unwinding of consumers’ excess savings from the pandemic continue to grow faster than aggregate supply (AS) because the global supply chain is still facing numerous challenges – some ephemeral and some more durable. While it seems excessive to call this a demand shock, that phrase at least describes the underlying phenomenon. AD is growing more strongly than AS is growing. Under those conditions, the economy continues to grow, but the price level in the economy rises, producing inflation.
 

What is not happening?

We are not repeating what occurred during the 1970s. Excessive inflation of the 1970s occurred because of a damaging combination of idiosyncratic factors.

1. Then: The U.S. government took the dollar off the gold standard. That caused the dollar to plummet, pushing up prices of imports, including some with few or no substitutes. 
   Now: The dollar remains strong, keeping the price of imports in check. Though this has other consequences, inflation is not one of them.
   
   
2. Then: Oil embargoes, largely because of geopolitical events, occurred just as the U.S. was passing peak oil production in 1970. Back then the economy depended far more on oil (and derivative products) with no real substitutes, producing a true AS shock. 
   Now: Oil production has declined, but largely because investors (including major energy companies) are unwilling to invest in projects with poorer return prospects as the world shifts away from fossil fuel use. However, new sources of energy are not coming online quickly enough as demand continues to grow. 
   
   
3. Then: Productivity growth began to slow during the 1970s, which slowed growth in AS. In fact, much of the slowdown occurred in industries directly or indirectly related to energy. While high prices eventually incentivized new development of energy resources driving prices down, productivity continued to decline throughout the 1980s and into the 1990s.
   Now: After a lull following the Internet boom, productivity is (inconsistently) rising again. Ongoing investments in technologies like artificial intelligence, machine learning, automation and robotics, should continue to support productivity growth this decade. 

Ephemeral versus durable

This of course raises questions about how high will inflation get and how long it will last. To address that, we need to distinguish between cyclical disruptions associated with the pandemic and more structural disruptions. On the AD side, the pace of growth will almost certainly slow as consumers spend excess savings, fiscal stimulus fades and interest rates increase. Moreover, the shift in consumption back to more normal relative patterns (more services consumption less goods consumption) will also help since there are relatively greater constraints on goods production right now. On the AS side, continued vaccinations will reduce disruptions from the pandemic and make people feel safer about returning to work while hiring should continue as the labor market tightens.
 

But we see four key areas where supply growth will remain muted:

1. Energy - for the reasons mentioned above, energy supply growth will likely lag behind demand growth until investment increases. 
2. Housing – structural shortages of housing are well understood. While supply is doing its best to increase, demand growth should slow due to slowing rates of household formation and population growth. The combination of both should alleviate some pressure.
3. Semiconductors – companies reduced excess capacity pre-pandemic after being penalized by investors. Consequently, the increase in demand for chips caught up to productive capacity and now companies need to invest to satisfy increased demand. New investments will take time to bring supply online. 
4. Labor – we have written for years on the structural labor shortage issue. The cyclical parts of this associated with the pandemic will lessen as the labor market tightens, but the structural parts due to demographic change will not. Investments in technology to boost productivity will occur out of necessity because of this labor shortage. But that will take some time to materialize. 

The Fed’s role

The Fed clearly cannot fix supply shortages. But they can use their tools to keep AD from running too hot while AS catches up. They have already announced tapering, although that will not fully complete until mid-2022. Thereafter, they will begin raising rates, and they might need to raise more aggressively than the market anticipates depending upon how inflation unfolds over the next few quarters. Either way, the Fed retains the most effective weapon in their arsenal to tamp down inflation. However, they will have to walk a fine line between cooling off AD and restraining financial conditions too much, which typically causes the average recession.

Outlook and Implications for CRE

We remain steadfast in our view on inflation. We see inflation coming down over time as AD cools, AS increases, and base effects in the economy make it more difficult to grow at a high rate. The base effects should begin to make a notable impact in the second quarter when year-over-year changes are calculated versus notably higher prices. Yet, because of the more structural shortages mentioned above, we continue to see inflation settling in above the level from before the last business cycle, by 50 to 100 basis points (bps). And of course, slowing inflation does not mean deflation. Outright declines in the price level almost always occur during a recession, like what occurred during the early months of the pandemic. 

We reiterate our view that commercial real estate (CRE) should continue to perform well during inflationary environments. We recently completed an econometric exercise that supported our view that while CRE offers an imperfect hedge against inflation, it holds up well as an asset class. We foresee rents being somewhat insulated but not immune due to either the short-term nature of leases that relatively quickly mark to market (for property types such as apartment and hotel) or inflation clauses embedded in longer-term leases (for office, industrial, retail). That generally helped to support valuations and cap rates.  
 

More specifically, we ran multiple econometric scenarios to better understand the risks to CRE associated with inflation. The main takeaway? The real risk to CRE from inflation would stem from AS growing much too slowly relative to AD for a more prolonged period, causing the Fed to raise rates more aggressively. That would cause too much of a clampdown on growth in the economy that would impact CRE space-market fundamentals and, ultimately, CRE capital markets. We do not foresee that in our base case, but risks to the downside case will build if inflation remains too elevated heading into 2023.

Note: Economic Insights will not publish next week. Happy Thanksgiving!