By: Nathan Metheny, Managing Principal/Co-Founder
Fed Reinvents Inflation Policy
On August 27th, 2020, the Federal Reserve revealed a shift in a decades long-held policy towards inflation, veering away from the 2% annual target and adopting an average target rate. The time period that this average is calculated from was left for speculation, as the Chairman stated it was, "flexible." So, does it matter that the timeframe was not specified? Yes, it does. According to Forbes, if you start from 2012, a 3.2% rate will be needed for the next five years in order to hit the average 2% target. Alternatively, if you start from the 1960s, deflation would be needed in order to reach the target.
So, what is inflation and how does it apply to real estate? Inflation is a general increase in prices and fall in the purchasing value of money. This especially happens when the government prints money and injects it into the overall money supply. In the past, the inflation rate target has been an annual rate of 2% - meaning that in a year, your dollar will only be worth 98 cents in today’s purchasing power. In 10 years, the same dollar will only be worth 82 cents in today’s purchasing power. According to the revised strategy, as mentioned, the Fed is adopting a policy that changes their annual target to an “average” target rate of 2% over the course of an unknown timeframe. This means a higher annual inflation rate will be tolerated due to shortfalls over the past decade. According to former Fed chairman Ben Bernanke, “The changes will increase the accommodative power of policy. When you go into a recession, markets will expect a longer period of easier policy and that will, in turn, increase the amount of effective stimulus.”
While the macroeconomic benefits can be arguably be seen in the increased ability of economic stimulation, the risk is equal and could lead to uncontrolled inflation with difficulty constraining the rate. Additionally, the policy does not consider the average American, who will be forced to pay the increasing bill of the invisible “inflation tax.” It would not be out of the question to see 6-10% inflationary periods; at a 10% rate, in 10 years, your dollar would be worth 38 cents in today’s purchasing power. That is a potential 62 cent inflation tax on your dollar, on top of visible taxes paid each year. Although the 1776 rate of 29.78% or the 1947 rate of 14.65% may be far-fetched, and even a 10% inflation rate seems beyond reach, investors should be prepared, nonetheless.
After discussing inflation with many economists, a majorly common theory is that inflation may be an extinct issue. There are many variables, but a primary argument is that a highly developed nation can maintain a certain productivity growth rate to combat inflation rate increases. Several points lead me to conclude that that may not be the case. The United States has certainly seen an exponential increase in technological and productivity advances in the past 30+ years, allowing the nation to enjoy minimal inflation rates - but is this still the case? According to the Bureau of Labor Statistics, the productivity growth rate maintained an average of 2.3% from 1947 - 2007 and 2.7% from 2001 - 2007; the growth rate since has averaged 1.1%. Although growth rate has increased slightly since 2017, the long term trend is well below average. If ever there was a time for efficiency and productivity growth to slow, a period of unprecedented money printing and relaxation of monetary policy is not the time.
Also in response to the inflation extinction argument, I point to international currency valuation. The tremendous increase of money supply weakens the dollar's value in relation to alternative world currencies. When a devaluation of the dollar occurs in relation to world currencies, more of the dollar is needed in order to purchase goods from said countries; hence, product prices increase, the purchasing power of the dollar decreases, and inflation is seen. Although most countries are printing their own fiat currency in order to slow the coronavirus recession, none are on the scale of the United States, insuring that a dollar devaluation will occur. In fact, as of this writing, the dollar's weakness is as concerning as it has ever been. Larry Hatheway with Barron's writes an eery article outlining this growing issue, titled, "America’s Economic Model May Have Peaked. The Dollar’s Strength Goes With It."
Ok, so based on the above arguments, let's assume inflation will increase. We know what inflation does to the purchasing power of your currency, but what does it do to assets? To provide inflation perspective, the Dow Industrial Average (DJIA) can be priced in gold rather than the US dollar, eliminating inflationary bias. Once the DJIA is priced in gold, it is shown that there have been minimal gains in absolute value. The seemingly high value that is shown when the DJIA is priced in dollars is largely due to inflation, and synergistically, the depreciation in the value of the dollar. This can be seen in nearly all asset classes.
Dow Jones Industrial Average (DJIA) 100-Year Historical Prices
Dow Jones Industrial Average (DJIA) 100-Year Historical Chart Priced in Gold
Combating the Inflation Tax
Combating the inflation tax is imperative in wealth creation and preservation. To combat the inflation tax, investments can be made in assets such as real estate. When investing in real estate, there are three main benefits in regard to inflation.
1. Asset Values
The value of your real estate investments rise with the rate of inflation and even outpace inflation in most situations, so rather than that $1 being worth 38 cents after 10 years in today’s purchasing power, it will be worth $1 or more. From the period 1967 - 2020, real estate prices have increased by 4.19% per year, in relation to 3.93% inflation rate during the same period.
2. Rent Growth
In addition to real estate values synergistically keeping pace with inflation, the cash flow produced from real estate investments through rent maintains pace as well. From the period 1984 - 2020, rent experienced an average increase of 3.31% per year, compared to the average annual inflation rate of 2.56% during the same period.
3. The Inflation Pay Down
The inflation pay-down may be the most overlooked benefit of real estate investment in regard to inflation. When an investment is purchased, it is usually done so with financing from a lender. Over time, the principal loan is paid down through regular recurring monthly debt payments, but to further compound that pay-down process, the principal balance is being devalued by annual inflation. For example, at a standard 2% inflation rate over the course of 10 years, a $100k loan will incur an inflation pay-down of $18k in addition to regular debt pay-down.
One thing is sure to come from the change in policy; increased inflation. To understand the intricacies of combating the inflation tax that all of us are subject to, reach out to the Wealthrise team. Positioning your portfolio in a way to minimize the inflation tax will grow and preserve your wealth in ways that the majority are unaware of.
Disclaimer: Information contained herein should not be considered investment advice. Wealthrise makes no representations or warranties and accepts no liability. We suggest that you consult with a tax advisor, CPA, financial advisor, attorney, accountant, and any other professional that can help you to understand and assess the risks and risk implications associated with any investment.
About the Author: Nathan Metheny is Co-Founder and Managing Principal at Wealthrise. In this capacity, his primary roles include acquisition supervision as well as setting the long-term strategy and trajectory for the company.