Inflation and Real Estate: An Introduction

The relationship between inflation and real estate is multifaceted, as both economic phenomena can influence each other in various ways. Understanding this relationship requires understanding inflation in general terms and then examining how inflation impacts different aspects of the real estate market, including property values, housing affordability, investment dynamics, financing costs, and consumer demand.

The Basics

Inflation refers to the overall increase in prices over time. While it is common for individual prices to vary, when prices rise in aggregate, one is experiencing inflation. Inflationary pressures within an economy can be driven by a combination of demand-side and supply-side factors. Demand-pull inflation occurs when aggregate demand for goods and services outstrips aggregate supply, leading to upward pressure on prices as businesses respond to increased demand by raising prices: The vast majority of the time, this results from an increase in the money supply; however, it is theoretically possible for this to happen because money is changing hands more quickly, an economic factor referred to as “the velocity of money.” Nonetheless, Milton Friedman once said, “Inflation is always and everywhere a monetary phenomenon.” While this may be an overstatement, he is not too far away from the truth.

Conversely, cost-push inflation arises from increases in the cost of production factors, such as wages, raw materials, or energy. When businesses face higher production costs, they may pass these expenses onto consumers through higher prices, contributing to inflationary pressures. This type of inflation can be particularly problematic as it may lead to a phenomenon known as “wage-price spirals,” wherein workers demand higher wages to keep up with rising prices, further fueling inflationary trends.

Measuring Inflation

Accurately measuring inflation is critical for policymakers, businesses, and individuals to understand economic trends and make informed decisions. As mentioned earlier, commonly used indices like the CPI (Consumer Price Index) and PPI (Producer Price Index) provide snapshots of price movements across various sectors of the economy. However, constructing these indices requires careful consideration of factors such as weighting, substitution effects, and quality adjustments to ensure they accurately reflect changes in the cost of living.

The Consumer Price Index (CPI) and the Producer Price Index (PPI) are both important indicators used by economists and policymakers to track inflationary trends, but they serve different purposes and reflect distinct aspects of the economy. The CPI measures the average change in prices of a basket of goods and services purchased by households over time. It includes a wide range of consumer goods and services, such as food, housing, transportation, healthcare, and education, making it a comprehensive gauge of consumer inflation. The CPI is widely used to assess changes in the cost of living and to adjust wages, pensions, and social security benefits to account for inflation, ensuring that individuals’ purchasing power is maintained.

On the other hand, the Producer Price Index (PPI) focuses on changes in the prices of goods and services at the wholesale or producer level. It tracks the average change in prices received by producers for their output, including raw materials, intermediate goods, and finished goods. The PPI provides insights into inflationary pressures within the production process and is often considered a leading indicator of future consumer inflation. Changes in producer prices can affect businesses’ costs of production, profit margins, and pricing strategies, ultimately influencing consumer prices downstream. As such, the PPI is valuable for businesses, investors, and policymakers seeking to understand inflation dynamics within the supply chain and anticipate broader economic trends.

Additionally, it is essential to distinguish between headline inflation, which includes the prices of all goods and services, and core inflation, which excludes volatile components such as food and energy prices. Core inflation offers a more stable measure of underlying inflationary trends, helping policymakers to formulate more effective monetary policies.

Economic Models: From the Phillip’s Curve to Rational Expectations

The study of inflation by economists has evolved significantly over time, marked by changing theories and models. Two key concepts in this evolution are the Phillips Curve and Rational Expectations.

1. Phillips Curve

Named after New Zealand economist A.W. Phillips, the Phillips Curve was introduced in 1958. It depicted an inverse relationship between unemployment and inflation based on empirical data from the UK between 1861 and 1957. The original Phillips Curve suggested that as unemployment decreased, inflation would rise, and vice versa. The Keynesian understanding of this posited relationship was that increases in aggregate demand, initiated by an increase in the money supply, would stimulate employment as production expanded and that this, in turn, would cause companies to compete for an ever smaller labor pool: These higher labor costs would then be passed on to consumers. Economists and policymakers in the 1960s believed that they could manipulate the economy to achieve lower unemployment rates at the cost of slightly higher inflation, and vice versa. Economic policy in their minds then consisted of “steering the ship” by balancing the two.

2. Rational Expectations

In the 1970s, the concept of Rational Expectations emerged, challenging the assumptions underlying the Phillips Curve. Rational Expectations theory, pioneered by economists like Robert Lucas and Thomas Sargent, posited that individuals form expectations about the future based on all available information, including past experiences and government policies, and that these expectations might cause the relationship embedded in the Phillips Curve to degrade over time. 

Changing inflationary expectations drive the movement of the short-run Phillips curve. Assuming workers possess complete rationality and information, they will notice that their nominal wages have failed to keep pace with inflationary increases, thus reducing their real wages. Consequently, they will anticipate higher inflation rates and endeavor to adjust their nominal wages accordingly to maintain consistent real wages in the future. This upward adjustment in nominal wages translates to heightened production costs for suppliers, resulting in diminished profits. 

As profits decline, suppliers reduce output and trim workforce numbers. Consequently, attempts to alleviate short-term unemployment by tolerating higher inflation ultimately lead to increased inflation and persistent unemployment in the long term.

Key points:

Adaptive Expectations vs. Rational Expectations

Rational Expectations argued against the idea of adaptive expectations, where people merely extrapolate past trends to form future expectations. Instead, it proposed that people incorporate all relevant information into their expectations.

Policy Ineffectiveness Proposition [The Lucas Critique]

Rational Expectations theorists argued that attempts to exploit the Phillips Curve trade-off would be futile in the long run. If policymakers attempted to reduce unemployment by increasing inflation, people’s expectations would adjust, leading to higher inflation without any lasting reduction in unemployment. Even if unexpected inflation had effects on unemployment, once the government starts pursuing it on purpose people can anticipate it, which can produce very different outcomes.

Evolution and Critique

Over time, economists have refined their understanding of inflation and its relationship with other economic variables. The Phillips Curve and Rational Expectations theories have both undergone modifications and criticisms:

Expectations-Augmented Phillips Curve 

This model integrates the idea of rational expectations into the Phillips Curve framework, suggesting that actual inflation depends not just on current unemployment but also on expected future inflation.

New Keynesian Economics

This school of thought retains some elements of the Phillips Curve while incorporating rational expectations and other insights from microeconomics, such as imperfect competition and nominal rigidities.

Critiques

Critics of the Phillips Curve argue that it oversimplifies the relationship between inflation and unemployment and ignores other factors influencing inflation dynamics, such as supply shocks. Rational Expectations theory has also faced criticism for its assumptions of perfect information and rationality, which may not accurately reflect real-world behavior.

Why do I think homeowners should understand this esoteric nonsense? 

The reason is quite simple. Despite the rational expectations critique, there are many at the Federal Reserve who still make use of the Phillips Curve idea as they do believe it works in the short run before people begin to adjust their inflationary expectations; you can often guess what the Fed will do regarding interest rates by looking at the labor market. When unemployment is low, they are much less likely to cut them while, if unemployment is high, they are virtually certain to. Yes, there is more to Fed decision-making than the Phillips Curve, but it is still an important part of their thinking.

In conclusion, economists’ understanding of inflation has evolved from the simple trade-off depicted by the Phillips Curve to more nuanced models incorporating rational expectations and other factors. The debate continues as economists strive to develop more accurate theories to explain and predict inflation dynamics.

Implications of Inflation

The consequences of inflation extend far beyond mere fluctuations in price levels. High or volatile inflation rates can introduce uncertainty into the economy, discouraging investment, and hindering long-term economic growth. Moreover, people are forced to change their behavior in order to hedge against inflation—and, generally speaking, when government policy forces people to change their behavior in a way that has no obvious social benefit, some sort of inefficiency occurs.

Central banks play a crucial role in managing inflation through monetary policy tools such as interest rate adjustments and open market operations [Buying bonds with newly “entered” money; no printing needed]. By targeting inflation within a specific range, central banks aim to maintain price stability and promote sustainable economic growth. However, achieving this delicate balance requires careful consideration of various economic indicators and a deep understanding of the complex dynamics driving inflationary pressures; not only is the task inherently complicated, but the timing must be close to perfect. Whether these challenges can be surmounted, and whether this sort of indirect regulation does more harm than good, is one of many ongoing debates in economics.

Inflation and Housing

Property Values

Inflation can affect property values in several ways. One direct effect is the impact on construction costs and materials. When inflation rates rise, construction materials, labor, and land acquisition costs tend to increase, leading to higher costs for developers. As a result, new construction projects become more expensive, which can constrain the supply of housing and put upward pressure on property values.

 Housing Affordability

Inflation can also affect housing affordability, particularly for prospective homebuyers. Rising inflation can erode the purchasing power of consumers’ income, making it more difficult for them to afford homes, especially in markets where property values are already high. Additionally, inflationary pressures may lead to higher mortgage interest rates, further increasing the cost of homeownership and reducing affordability.

Investment Dynamics

Real estate is often viewed as a hedge against inflation, as property values and rental income have historically demonstrated the ability to keep pace with or outpace inflation over the long term. As a result, investors may allocate more capital towards real estate assets during periods of high inflation, seeking to preserve the value of their investments. Moreover, real estate investments, such as rental properties or real estate investment trusts (REITs), can provide a steady income stream that may be less susceptible to inflationary pressures compared to other asset classes. That said, it is a much more effective hedge against persistent, long-term inflation than it is against unexpected inflation. Sudden increases in inflation can hurt property value by increasing interest rates, which tends to decrease demand for real estate. However, if the interest rate environment is stable, it can serve as an excellent hedge.

 Financing Costs

Inflation can impact financing costs for real estate transactions. Central banks may implement monetary policy measures to combat inflation when inflation rates rise, such as raising interest rates. Higher interest rates lead to increased borrowing costs for homebuyers and real estate investors, potentially dampening demand for property and slowing down market activity. Conversely, during periods of low inflation, central banks may adopt accommodative monetary policies, such as lowering interest rates, which can stimulate borrowing and fuel demand for real estate.

Inflation Expectations

Expectations about future inflation levels can also influence real estate market dynamics. If investors anticipate higher inflation in the future, they may adjust their investment strategies accordingly, favoring real estate assets that have historically provided a hedge against inflation. Similarly, homebuyers may rush to purchase properties to lock in lower mortgage rates before rates rise further, leading to increased demand and bidding wars in the housing market.

Overall, the relationship between inflation and real estate is complex and dynamic, with various factors shaping market dynamics and outcomes. While inflation can impact property values, housing affordability, investment decisions, and financing costs, real estate assets have historically served as a hedge against inflation. However, it is essential to recognize that the relationship between inflation and real estate is not simple and cannot be captured by any rule of thumb.

Franklin Carroll

Franklin Carroll is Kukun's VP of Modelling and Analytics; After finishing his studies at the University of Chicago, he worked at Fannie Mae where he helped build Collateral Underwriter, roll out the Value Verify initiative, and specialized in collateral related and credit related policy.

Published April 24, 2024