Higher prices are raising yellow flags about inflation. There are plenty of trends to monitor when it comes to assessing economic risks, but inflation is one of the most important. Changes to the upside could have a big impact on the real estate industry, because inflation can lead to higher interest rates. Deutsche Bank calls inflation the “mother of all risks” and according to CNBC, there are signs of it “popping up everywhere.” 
The central bank keeps a close watch on inflation, to help control both inflation and deflation. There are two readings on consumer prices that are important. One is the CPI or the Consumer Price Index. The other is the PCE or Personal Consumption Expenditures. Although we most often hear about the CPI, the Federal Reserve may tend to favor the PCE. There’s also a third measure of inflation for the manufacturing sector called the PMI or Purchasing Managers Index from IHS Markit.
Consumer Prices Rising
For the last five months, the CPI has been running over the Fed’s 2% target. And, from December 2016 to March of this year, it’s been running above 2% for 11 out of the 16 months. If you eliminate prices for gas and food, it’s typically been slightly below the 2% level over that same time period.
The PCE rate has been lagging behind the CPI at less than 2%, but the latest quarterly reading on the PCE was 2.7%. That’s a big jump, but probably nothing to worry about unless the PCE runs at a higher level more consistently, along with the CPI.
If you are wondering why they show different readings, it’s because they place more or less importance on various pricing categories. 247WallStreet offers a few examples of how they differ. In the CPI, shelter accounts for 31% of the reading. For the PCE, it’s 15%. Transportation costs amount to 17% of the CPI and just 10% for the PCE. Those percentages reversed for medical care with the PCE placing much more weight on those costs .
Producer Prices Catching Up
There’s also another measure of business activity and inflation for the U.S. manufacturing sector. The Purchasing Managers Index from IHS Markit is a survey that asks companies if the level of business activity is higher, the same or lower than the previous month.
The latest reading shows that U.S. companies grew faster in April than they have in three-and-a-half years. In April, the index hit 56.5. Anything over 50 indicates economic expansion, and that number is the highest since September 2014.
The PMI shows, the cost of raw and partly finished goods increased at the fastest rate in five years. MarketWatch analysts say, as orders increase, companies are also running into tight supplies, and that’s pushing prices higher. Oil prices are also adding to price inflation. Companies say, tariffs on foreign imports like steel and aluminum, and higher prices for some products from China are a response to U.S. tariffs .
CNBC’s Bob Pisani believes inflation is becoming an issue. It’s earnings season, and he says there’s been more mention of higher prices by various companies. 3M says it’s been paying more for transportation and raw materials. Kimberly-Clark says inflation is impacting its margins. And, Proctor & Gamble says earnings are lower due to inflation.
Federal Reserve Target
The Federal Reserve would like to see inflation humming along at 2. The CPI is the only inflationary measure that has been running consistently ahead of that mark. But, if the other two started to show more break that 2% barrier more often, that could lead to more aggressive interest rate hikes.
That said, Bloomberg Markets reported, Fed Chief Jerome Powell may be willing to tolerate inflation as high as 2.5% to help keep the economic expansion motoring along. If that’s the case, short-term interest rates may not do very much in the foreseeable future. We’ve had six rate hikes since the Great Recession, and one, so far, this year. While the central bank is expected to hike rates two more times in 2018, some economists are predicting another three rates hikes.
At this point, there are signs of inflation, but it isn’t racing ahead either. An economist from BMO Capital Markets, Sal Guatieri, told CNBC, “U.S. inflation is warming up rather than heating up.” We’re not at the red flag level yet. The flag is still yellow.
There are several ways that inflation affects real estate. Higher inflation can indeed drive interest rates up. It also can devalue the dollar, which drives up the value of hard assets like real estate. Paper assets, like currencies, and the U.S. Dollar, lose value in an inflationary environment. So if you have a lot of cash, it might not be worth as much. Similarly, if you have a lot of debt, it also becomes worth less with inflation.
Bad debt, like high interest credit cards, is never good. But good debt, like 30-year fixed rate mortgages, becomes even more valuable with inflation. For example, if inflation drives rents up, but an investor is locked into a fixed payment, cash flows increase.
Also, if one dollar is worth fifty cents over time, then the value of debt feels like half as much as well, and can become easier to pay off. That’s why many real estate investors say, it’s smart to take on lots of good debt, long term debt at low interest rates, when we are in an inflationary climate like today.
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