Inflation and Real Estate

Much has been made of the potential for inflation in the United States lately.  Most of this speculation is due to the enormous budget deficit seen in the US, exacerbated by the multiple stimulus packages enacted during the recent recession as well as the increase in the monetary supply based on actions from the Federal Reserve.  Despite this there are still many out there that don’t believe inflation will be a problem in the future.  I will discuss some scenarios I believe are likely to happen and how they will cause inflation to rise.  I will then discuss the implications for real estate in an inflationary environment.

The US has a huge fiscal problem.  Currently, we spend MUCH more than we take in as income (on the order of $1.7 Trillion for 2011).  While there are multiple reasons for this (and it’s probably best to not get me started) the fact of the matter is our country is nearing a point where something has to be done as investor confidence is already being shaken.  The total national debt is currently over $14 Trillion dollars and this doesn’t even include future obligations for medicare, medicaid and social security (although, over $4T is money the gov’t owes itself in the form of social security & medicare trust funds).  In the long run the US has the option of either not making some or all of these payments (defaulting) or it can crank up the printing presses and send out suitcases of cash, mafia style, to all of its creditors.  I suppose the government could also cut spending to below the level of income that was raised, thereby paying off the debt little by little… hahaha, sorry, thought I would check to see if you were paying attention.

Default by the US would be very bad and would be a potentially government ending, revolutionary type moment for our country with panic and blood in the streets.  Obviously, the exact circumstances of the particular default would be of huge importance, but being that as it is, given the two options, the government will lean towards printing more money.  More money in the system, all other things being equal, leads to each dollar being worth less in purchasing power than it was before.

Related to the governments fiscal problems is the Federal Reserves policies regarding the money supply, particularly the responses to the financial crisis, including QE 1 & 2.  Amazingly, with the large amount of money being lent out the money supply has not increased all that dramatically.  Although this might be surprising at first it makes sense when you look at who the recipients of the cheap, or even zero cost money loans are – the banks and other financial institutions.  These organizations have taken the money given to them from the various bail out programs and have piled into government securities.  The yields aren’t all that great on government bonds right now but when you are borrowing money at no cost from the government or through demand deposits, then a yield of 1.71% from a 5 year treasury bond isn’t that bad.  However, since this money isn’t going to loans for individuals or businesses this money isn’t being multiplied.  In the not too distant future I predict that banks will decide that by increasing their risk tolerance slightly they will dramatically improve their profitability.  It will take one bank to have an absolutely blowout quarter by offering financing on slightly more liberal terms before everyone else jumps back in.  When this happens you have the multiplier effect of pent up bank balance sheets unleashed – leading to what could be a huge increase in the supply of money, leading to a large devaluation of the dollar in comparison to hard assets.

Obviously, this is a brief explanation of a couple of scenarios that could play out in the near or later future that would trigger inflationary pressure.  Inflation is a topic that has been studied in great detail and there are multiple books that have been written on this single topic.  Nevertheless, if I missed something or if you have a question regarding anything I talked about, leave a comment and I’ll do my best to answer you.

I will post a follow up article on why investing in real estate makes sense for anyone who is expecting inflation, or who just wants to hedge against the possibility of inflation.  However, in brief, real estate is considered a hedge because it is a hard asset.  It’s value is not tied up in dollars, therefore the change in the value of the dollar is irrelevant because the price of the asset will adjust upwardly as the dollar loses value.  Obviously, there are other factors likely going on at the same time which could affect the value of real estate, namely economic activity at the time but other factors constant, inflation won’t effect the value of real estate in real terms.  In nominal terms, the value will increase at the rate of inflation.

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