Research

Is inflation becoming
a bigger problem?

…and what does that mean for commercial real estate’s role as an inflation-hedged asset class?

March 03, 2021
>> Quick takes:
  • Interest in inflation clearly expanding
  • Concerns stems from both monetary and fiscal policy
  • Expect inflation to increase, but not excessively
  • Asset price inflation differs from goods/services inflation
  • CRE’s inflation hedge could see renewed importance

We can almost always tell when an economic issue rises to the front of public (or at least client) consciousness because of how frequently we receive questions on a topic. Recently, and in particular over the last week, the topic of inflation increased in importance and we felt it important to address.

Why the rising concern?

Concern has increased because some believe that the policies under consideration, particularly in the U.S., could inflate prices at a disruptive rate. The fundamental issue: that aggregate demand (AD) in the economy will increase faster than aggregate supply (AS), pushing prices upward. This concern arises primarily from two areas. On the monetary policy side, observers have grown concerned that a rapid increase in the money supply, coupled with low policy rates, will spur AD. On the fiscal policy side, they fear that stimulus via government spending and transfers to consumers will bloat AD. If AS growth lags behind AD growth, the size of the economy can grow, but prices increase.

What factors are amplified?

What factors will determine where equilibrium settles?
Though by no means an exhaustive list, below are some important factors:

Money velocity/excess banking reserves:
During the last expansion, many of the same arguments surfaced. Among the reasons that increased money supply did not spur AD, money velocity (how frequently money is used to purchase a good or service) declined. Why didn’t that money circulate? Various reasons exist, but a noteworthy increase in excess reserves on the balance sheets of depository institutions contributed. Essentially a lot of the money remained in banks. The personal savings rate also increased last cycle. Thus far, these phenomena are reoccurring. While that could change, a rapid reversal seems unlikely and does not appear in the historical data. 

 

Globalization:
The increased integration of markets and information over the last few decades helped to drive down inflation. The integration of both factor markets (production) and product markets (consumption) has helped to drive down costs. Better information flows also make markets more efficient, also helping to drive down costs. These have enabled efficient production and an increase in AS.

Demographics:
Across the developed world societies continue to age. This is a complex factor. Some evidence shows that AD declines in aging societies as the elderly consume less, particularly as households stop supporting children. Yet, aging in societies also tends to slow AS growth because the rate of growth in the labor force slows unless the size of subsequent generations increases. In many industrial societies, that did not occur – birth rates declined across most of the developed world including the U.S. Although relatively open immigration in the U.S. versus other developed nations has helped offset aging and a declining birth rate, labor force growth continues to slow. Empirical evidence suggests that the net impact produces slower inflation.

Technological improvement:
As technology advances it has enabled more efficient production, which means that firms can produce more goods and services with the same amount of input, typically labor and capital. This reduces firms’ cost of production and boosts AS.  In many cases, the marginal cost of additional production is near zero. Continued investment should help restrain cost increases.

Cost and availability of capital and natural resources:
Capital and natural resources have a large impact on AS. Summarizing the evolution of both over time falls beyond the scope of this article, but greater availability of both as well as reduced cost of both has boosted output and AS over time.

Changes in expectations of firms and consumers:
If firms and households feel more optimistic, this could change their consumption and investment plans, spurring AD. Consumers, which represent roughly 70% of GDP, could play a large role, particularly with consumers sitting on a large amount of dry powder/pent-up demand from increased disposable income and consumption that did not occur last year.

Geopolitical factors:
In the years leading up to the pandemic, some blowback against globalization existed. If that persists, it could undermine the cost benefits generated over the last few decades. If governments decide to produce redundancy in the supply chain to make supply chains more resilient, that could also increase costs as production at least partially shifts to higher-cost locations. Nationalism could create barriers against immigration, which could make labor markets less efficient, pushing up labor costs. Health screenings in the movement of goods and people could also add to costs. All of these would reduce the growth rate of AS.

Puffed up predictions?

The question of inflation depends on the definition of inflation. Our crystal ball foresees inflation increasing over the medium term, possibly rising to around 3%. But it seems improbable that inflation will increase to levels that will cause either disruption on its own (that tends to come from hyperinflation, when inflation greatly exceeds expectations) or from rapidly rising interest rates in order to tamp down inflation, but in the process stymying economic growth. Disruptive inflation implies AD growth consistently exceeding AS growth, which seems unlikely.

Disruptive interest rate increases seem unlikely, especially given the lessons the Fed learned last cycle and their relatively new inflation-targeting regime that targets average inflation through a cycle. Moreover, we should remember that the Fed’s mandate includes full employment as well as price stability. And the Fed will remain cautious about the former given the massive job losses during this crisis. Transitory inflation could certainly emerge, especially with base effects for inputs like energy prices and some supply disruptions, but those tend not to turn into more durable inflation and the Fed will see through that. Even as the Fed holds policy rates fairly steady, the long-end of the yield curve should move up as economic growth and inflation accelerates, steepening the yield curve, exactly what one would expect during a recovery/expansion period in the business cycle.

What about asset price inflation?

Many have wondered about rising asset prices in a world where structural inflation declined and remains tame. Though too numerous to exhaustively list, a few important reasons for this include: economic growth boosting asset earnings, growth in money supply exceeding growth in assets for purchase, a greater share of operating earnings paid to investors than to labor, and the declining cost of capital over time.  

|  What it means for CRE  |

Commercial real estate (CRE) clearly benefitted like other asset classes from asset-price inflation over the long run. Even if interest rates rise, other factors, like economic growth, should push valuations upward. Moreover, CRE retains an important role as an inflation-hedged asset class. The importance of that hedge seemingly diminished over time as inflation declined on a structural basis, but it has not gone away. Leases can and often still do retain inflation clauses. If inflation starts to accelerate as we think it will, that should favor CRE, particularly as new leases get signed. If inflation accelerates beyond our forecast, that might initially disadvantage some assets if their leases do not fully compensate owners. But ultimately the market will adjust and compensate landlords.