Published on February 1, 2022
Justin Miller
Principal, Co-Founder Chong Miller Group, LLC
Everywhere we look, we see prices going up – whether at the gas pump, the bakery, or the housing market. We read about inflation in the news and hear about potential interest rate hikes coming in 2022 to combat inflation. But what does this mean, and how will it impact the housing market?
Inflation is a generalized increase in the price of consumption. Inflation results from a combination of factors, but most basically from an imbalance in supply and demand. And right now, our economy is marked by significant supply-demand imbalances. Why?
Supply is constrained across the supply chain
Over the course of 2021, we were confronted with a number of challenges, most being spill-over effects of the pandemic. These have ranged from shortages on store shelves and shipping delays for appliances, to price increases and even changes in the ways and locations in which people work. The changes we experienced during 2021 were so many and so diverse, it can be easy to forget their common origin – and therefore it can be easy to misunderstand the residual impacts in 2022 and subsequent years.
Because we exist in a highly interconnected world, our needs are attended to by international supply chains that have been optimized over decades. That works well when goods and products flow freely, but interruptions in the normal flow of logistics creates challenges that reverberate throughout the economy. And the pandemic created massive logistical interruptions.
When factories shut down in China in late 2019, cargo ships at the Chinese ports of Shanghai, Hong Kong, and Shenzhen had no products to move, and so the ships remained docked. Ships returning to China from North America and Europe laid at anchor awaiting berths, while the shipping containers on those cargo carriers remained stranded at sea for weeks. To reduce operating costs associated with time-at-sea for ships and crews transporting raw materials to China, more ships remained stuck in port in other parts of the world.
Had the issue been localized to China, sea lane congestion would have cleared within a few weeks. But by the time Chinese factories started producing again, the ports for Los Angeles, New York, and Rotterdam were starting to close, leaving ships, containers, and products stranded at sea. And by mid-2020 when US and European ports were reopening, Indian ports were shutting down.
The result was a long series of catastrophic rolling shutdowns of the many nodes on the global supply chain. Ships and containers have been stranded out-of-place, all around the globe. Beyond the finished goods that were ultimately bound for wholesalers, those stranded shipping containers also were full of raw materials and semi-finished goods headed to manufactures. That meant when factories opened, they often had materials shortages that prevented them from operating. And that extended the effects of the initial shutdowns.
Many economists had forecast that by early 2022, ports, cargo ships, containers, and factories would all be operating normally again. But the Omicron variant has played havoc with that timeline. It appears the peak of this wave may now be passing in the US and Europe, but China has just shuttered several of their largest ports and has locked down a few large cities to contain this variant. Assuming Omicron is the last variant of concern, it will be late 2022 before the global supply chain is operating at full capacity. And if there are other highly transmissible COVID-19 variants, this problem will continue still further into the future.
So that’s what’s happening to supply. But what about demand?
When US state governments ordered a halt to most economic activity in March 2020, they created an obvious shock to the economy. Without work, unemployment rates skyrocketed. In Las Vegas, for example, unemployment went from about 4% to more than 33% – almost overnight. Fortunately, there were several support programs created, significantly offsetting the financial impact of unemployment. In fact, between unemployment insurance and pandemic unemployment ‘benefits,’ most people making less than $53,000 received income replacement equal to, and sometimes greater than, the wages they would have earned.
While these ‘benefits’ were not evenly distributed, with some people having to continue working in grocery stores, trash pick-up, and other ‘essential services,’ the overall financial burden of the lock-down was significantly attenuated. Actually, overall income statistics produced by the Bureau of Labor Statistics showed income rising during most of 2020 and 2021, personal debt-levels declining, and savings rates increasing substantially. Additionally, student loan debt repayments were suspended and support for struggling homeowners was provided via loan forbearance, and renters via eviction moratoria.
While this certainly impacted the national debt, individuals were spared from most of the financial negatives of a shuttered economy. While people were not working, not producing goods or providing services, they were being paid. And those payments allowed consumers to continue purchasing goods and services. In the aggregate, consumer demand remained surprisingly resilient.
But that strong demand increasingly ran into limited supply. And what happens when demand exceeds supply? In a market economy, prices increase. And hence, inflation.
Types of inflation
With that primer, it should be noted not all inflation is the same. Demand-driven inflation results from excess demand chasing existing supply: we see this in the housing market. Due to low interest rates, demographic shifts, and altered employment/commute patterns, demand for housing has accelerated and existing supply is too little to accommodate the increasing demand. Supply-driven inflation, on the other hand, occurs when supply decreases and is no longer able to supply existing levels of demand. We see this clearly in the infamous toilet paper shortages of 2020. Demand for toilet paper was mostly consistent (except for some hording), but supply became very constrained. That led to shortages, and shortages are ‘cured’ with higher prices (or purchase limits, i.e., rationing).
Why does this matter? Because demand driven inflation derives from greater ‘wants’ by consumers, people come to expect they will have to bid up the price they offer for the items they want. This expectation of Inflation creates significant policy challenges, and governments strive to dampen consumers’ expectations of inflation by doing things that decrease consumer demand.
Supply-driven inflation is different, as it can only be cured with more production. As long as consumers do not develop a generalized expectation of inflation, the government can cure the issue by inducing additional supply through various policy prescriptions. These policies may take the form of tax rebates for expansion of certain types of factories, the building of more roads and ports, or other forms of incentives and support for additional supply to enter the market.
This is where Interest Rates come into the picture
We can think of Interest Rates as the price of money. If you want to ‘buy’ money, you’ll pay interest for the privilege. Increasing interest rates mean the price of money is increasing. This is not considered ‘inflation,’ as money is an asset class – and increasing prices of asset classes are omitted from inflation calculations.
But where do interest rates come from? Some rates are set by the government, specifically the Federal Reserve (FED). Other interest rates are set via a market mechanism – the issuance and trading of bonds. In the US, the FED is tasked both with keeping inflation low and also maintaining ‘full employment.’ The FED uses its influence over interest rates to accomplish these two mandates.
To keep demand-driven inflation low, the FED can restrain demand by increasing the price of money (raising interest rates). More expensive money makes borrowing, and hence all the buying of goods and services that is supported by borrowed money, less appealing. The specific mechanisms the FED uses to alter interest rates is beyond the scope of this article, but in general the tools are blunt instruments with slow and imprecise effects. But those interest-rate tools are of little use in curing supply-driven inflation. The cure for supply-driven inflation is to increase supply. In fact, to the extent higher interest rates making investment in new factories and production lines more expensive, they act contrary to requirements. And so the FED must be careful in its use of interest rates, otherwise it could inadvertently induce additional inflation by further aggravating supply problems.
So where are we now?
While inflation has increased during 2021, it’s not actually that high. In 2021, inflation shot up to 6.7%. From 1990 through 2020, US inflation was running an average of 2.42%. We’re clearly running higher than the average of the past three decades. But does the type of inflation suggest anything?
According to the Commerce Department, semiconductor demand increased 17% from 2019-levels (demand-driven), but supply is also down (supply-driven). So the situation is complicated – part of the current inflationary environment is being driven by excess demand. But supply constraints are real, at all parts of the supply chain. And therefore the policy prescriptions for solving the current inflationary environment are also complex.
Increasing interest rates will slow demand growth, but potentially restrain supply growth. Fiscal policy responses, such as the CHIPs legislation pending in the US House, devote money to stimulate investments in microchip manufacturing. Additional legislation is designed to increase efficiency of ports. These are not short-term fixes, as infrastructure investments take time. But if the FED raises interest rates too high in dealing with transitory inflationary pressures caused by supply constraints, they could cause a recession (a generalized downturn in economic activity). And that runs contrary to the FED’s second mandate – maintaining ‘full employment.’
The policy suggestions are then, small increases in interest rates, and significant fiscal investment into infrastructure and manufacturing. In this regard, the FED has indicated they plan 3 interest rate increases this year, each of 25 basis points (a total of three-quarters of one percent). This is in-line with the interest rate prediction I made last November, and also conforms to predictions from the National Association of Realtors. The Mortgage Bankers Association (MBA) is predicting four increases (a full one percent increase in rates).
What does this mean for housing?
At the end of 2021, mortgage interest rates were about 3.1%. An increase to 3.85% (or even to 4.1%, per the MBA) would increase the monthly carry cost of an 80% loan-to-value mortgage for the median priced ($425,000) home by $140 (or $190) per month. While this may push some people out of the market, the actual difference in monthly payment is pretty minor. As such, it seems unlikely this level of increase in interest rates will significantly impact demand for housing. There may also be some more targeted measures to restrict demand in particular domains. But over the past 20 years, the US FED has shown no desire to slow the rate of asset price growth – and so interest rate increases that negatively impact housing (or stocks) are highly unlikely.
Of course, higher levels of inflation also make living more expensive. With higher prices for gas, food, and entertainment, some additional people may find they have less ability to save for a down payment. And therefore, inflation in consumer prices may restrict some level of home purchase activity.
Given that both inflation and interest rates may make it harder to purchase a home, the history of interest rate trends is interesting. As rates increase, more people move into the housing market to ‘lock-in’ more favorable (lower) interest rates. In fact, in all periods of increasing interest rates since 1978 (with the single exception of 2006), increasing interest rates corresponded to increasing prices of real estate. In other words, the purchase of housing is the purchase of an asset class, and therefore the demand implication of increasing costs are not the same as for purchases of consumer consumption goods and services. Interest rate trends in 2022 will not negatively impact housing demand or prices.
And why do I say housing is an asset class? Because it is itself both an investment vehicle, and a hedge against inflation. In 2021, Las Vegas single family houses increased (at the median) 25% (or $85,000). That represented a massive increase in the net worth (wealth) of most owners. And higher interest rates will not alter the wealth implication of real estate investment – for primary residences, second homes, or ‘investment properties.’ We can look forward to more wealth building in 2022.
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1 Note, inflation relates to the price of consumption, and is therefore measured by changes in the price of consumer expenditures. Increases in the price of various asset classes (i.e., stocks, precious metals, currencies, real estate) are not considered inflation.
2 When you ‘buy’ an asset, you’re buying it for some period of time. When you ‘buy’ money, we call this ‘borrowing,’ and hence the price of money is the interest you’ll pay during the time you ‘own’ that money.
3 Inflation is highly variable, and from 1914 to present has ranged between 17.45% and -10.67%. Between 1990 and 2020, the rate ranged from 5.42% to -.23%. Sudden changes to US inflation have generally been short-lived spikes and dips.
