John M. Lee: Is Inflation Here?
Has anyone noticed that our gasoline prices are up? How about PG&E bills? Airfare, gold, coffee? Soybeans, insurance, food? The pricing on just about everything has gone up these past few months and will continue to go up as our economy gets better.
In economic terms, inflation is defined as a rise in the general price level of all goods and services. The general price level thus varies inversely with the purchasing power of a unit of money, such as the U.S. dollar. For example, if prices double, purchasing power decreases by one half. If prices halve, purchasing power doubles. Therefore, inflation is also a reduction in the purchasing power of a unit of money.
Inflation is most often measured with the Consumer Price Index (CPI). The Bureau of Labor and Statistics puts together average prices for items such as food, energy, housing, apparel, transportation, education and medical care; and calculates how much it changes over time. In the past few years, we have not had much inflation and, in fact, price levels actually decreased in a couple of those years. Normal inflation rates of four to five percent a year is generally accepted as being the signs of a healthy economy. By that measure, the last time we experienced any type of real inflation was between 1997 to 2001, when we were at between five to nine percent.
With the price increases we are seeing currently, which propagates throughout all of our expenditures and most commodities, our leading economic indicators are all pointing positive, such as unemployment numbers going down, consumer confidence going up, corporate earnings improving and the stock market performing well. These factors will lead to more jobs and more money being available, resulting in higher inflation. What does this mean for real estate?
For one, long-term interest rates will go up. We have been hovering at the five percent mortgage interest rate level for several years now and with the federal government about to make some radical changes to the secondary mortgage market, interest rates have nowhere to go but up. The Feds have been waiting for the right time to execute its plan, a time when the economy is gaining some momentum as to limit the damages to an already battered real estate market.
For those who already own real estate and are locked into a fixed-rate mortgage, the upcoming inflationary period might not be a bad scenario. In San Francisco, most new owners are spending about 40 percent of their income on housing, and if their income goes up because of inflation and their housing expenses stay about constant, they will be paying off the loan with post-inflation dollars, which are worth less than pre-inflation dollars.
For example, it is much easier to make a $3,500 mortgage payment today than it was 15 years ago because $3,500 is worth less today and people make more money. The same will apply to the future. With inflation, income rises, prices rise, and so does the value of all hard assets, including real estate. So, real estate prices will go up, providing a double boost for homeowners.
Academic research has shown that real estate is a hedge against expected and unexpected inflation, meaning that it is the perfect hedge if one believes that inflation is on the horizon. And the reasons are that tomorrow's earnings are paying off the mortgage, and that inflation leads to higher prices. No wonder my parents, who did not really understand economic theory, advised me to buy as much real estate as I could!
John M. Lee graduated with an MBA from UCLA and currently is a real estate broker at Pacific Union, specializing in the Richmond and Sunset districts. If you have any questions about real estate, call Lee at (415) 447-6231 or send an e-mail to johnlee@ isellsf.com.