When the President is forced to acknowledge the risks of inflation, you know it’s bad.
On November 10th, President Biden stated, “Inflation hurts Americans’ pocketbooks, and reversing this trend is a top priority for me.” In the UK, the Governor of the Bank of England issued a public apology for the pain caused by soaring prices.
To answer this question, I first went to crack open my favorite dog-eared textbook on commercial banking; after all, 2 of the top 5 mortgage lenders in the US are still banks, and banks comprise a significant share of funding to non-bank originators. According to a recent NAR study, 87% of buyers finance their home purchase, so mortgage lending is a key driver of the housing market.
I flip to the index of the textbook; individual retirement accounts, industrial organization model, inefficient management hypothesis, influence peddling….huh, no mention of inflation. OK maybe this is an older textbook, written during a goldilocks period when inflation was viewed as permanently “whipped.” But surely, in 2021, bankers are taking this seriously. Let’s go to the 17 page course catalog for one of the top bank executive training programs in the US. Enterprise Risk Management - 22 mentions; Liquidity - 8 mentions; Profitability - 11 mentions; Inflation….well apparently I am stuck googling pithy quotes, because no one wants to teach me about how banks will respond to inflation. Luckily a former California State Controller summed it up neatly, describing inflation as a process by which you get to live in a more expensive neighborhood without having to move.
I had the chance to discuss this topic with one of the foremost inflation experts in the world, Paul Volcker, many years ago; his view was that there is no such thing as a good inflation rate; the appropriate inflation rate is 0% and any deviation from that is harmful. Based on my own experience in financial markets, what has caused the most harm is volatile inflation, or unpredictable inflation. This ties into Volcker’s theory in the sense that if you are aiming for a “stable” but non-zero rate of inflation, you are setting yourself up for more volatility than if you aim for 0%. And typically, if inflation overshoots, which in asset price terms can be called a bubble, it might be followed by a crash, and this boom/bust cycle can wreak havoc on a leveraged financial system, and a leveraged asset class such as residential real estate.
On the other hand, a realistic approach to the currently leveraged financial system is as follows: deflation (inflation rate <0%) is unacceptable, because it can cause leveraged firms to default on their obligations, because their debt is fixed in nominal terms, but their earnings power is variable; and if you aim for an inflation rate too close to 0%, then you are running too high a probability of getting deflation; therefore, it is best to target a moderate inflation rate to optimize financial system stability.
Inflation shows up in the housing market in the form of higher rates on loans, higher costs for construction labor and materials, higher rents, and higher home prices. The Federal Reserve is tasked with achieving stable prices in the economy; one of their tools for doing that is raising interest rates when inflation is above target. We are in an unusual period where inflation is high, but interest rates are near all-time lows. The thought experiment you have to run is, what happens if more and more people believe that inflation will remain high and/or accelerate, rather than being transitory? How much money would you keep in your checking or savings account paying 0%, when inflation is 5-10% per year? If everyone responds by pulling money out of their bank to hedge against inflation (whether it is putting it in art, bitcoin, gold, stocks, real estate, commodities, etc.), what will happen to the banks? Can banks jack up deposit rates to keep people from moving their money into better inflation hedges? If they have to jack up deposit rates, won’t they then have to pass those through in the form of higher loan rates? If the Fed is determined to keep rates low, can it allow these private deposits to flee and be the depositor of last resort? As you can see from this thought experiment, high levels of inflation mixed with ultralow interest rates is not sustainable, and one should expect them to converge over the next 12 months.
The Fed will have to act by raising interest rates if inflation is high beyond expectations. This means there is an upside risk to mortgage rates in 2022. Therefore, locking in low borrowing rates now is a prudent measure.
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