Price Stability, the Real Estate Hedge and the Federal Debt

In battling unemployment, the central bank’s toolbox is limited to fairly blunt instruments. Its ultimate power rests in its ability to set the overnight rate. The Fed also exerts its influence over the market for Treasuries and other securities, though its sway is limited in this arena. In balancing interest rate policy with price stability, the Fed has been able to exercise a relatively free hand in the absence of higher rates of inflation.

The Fed’s interventions since the onset of the financial crisis have left open the potential for unexpected inflation. The mechanisms of transmission are reasonably well understood for textbook policy moves. But as Professor Paul Krugman, the economist and New York Times columnist, aptly pointed out in a column last August, “the crisis and slump have been a testing ground for economic doctrines.” Natural experiments have been joined by policy choices that depart from the textbook, fueling a charged debate (by economists’ standards) on the future direction of prices.

We don’t have worrisome inflation now, in spite of the rapid expansion of the money supply. Among other factors keeping prices in check, the velocity of money is at its lowest level on record. The money is there; it’s just not moving around. That will change as the economy improves and strong liquidity preferences soften. At that juncture, inflationary pressures could rise quickly. If you care about managing risk, you can’t afford to dismiss the scenario on the grounds that the causal linkages aren’t in place today.

Here’s where real estate’s cognoscenti weigh in. As the axiom goes, real estate is the asset class of choice when inflation is eroding the value of other investments. If you’re lending at the lowest interest rates of our lifetimes or have any exposure to conventional debt, you know the story is more nuanced—that there are both winners and losers in the debt and equity stacks, and that not every property will serve as an effective hedge for its owner.

Even with an imperfect hedge, real estate’s comfort level with inflation raises another question that has gained some currency in our profession. For all the grumbling about the federal debt, why not take a more permissive view and let inflation solve the problems that Congress will not? Cocktail-party conspiracy theorists posit that the Fed has intended as much from the outset and that maturity extension is one step in the process. They might also point out that inflation-protected Treasuries account for a small portion of balances outstanding. Whether premeditated or not, inflationary approaches to reducing the real debt burden can boast a bevy of powerhouse thinkers, from the Charles River to Locust Walk, who will afford the concept some merit.

Even the idea’s proponents caution that it cannot be sustained beyond the short term, nor can it serve as the substantial solution to the structural deficit. Forget that inflation doles out costs and benefits unevenly. Among the reasons it won’t work for long as a legacy debt-busting strategy, new and maturing debt would need to be financed at higher rates, increasing the nominal interest burden. Enough of the government’s ongoing and mandatory obligations are indexed to inflation that real deficits will persist.

The term structure of the debt suggests a brief burst of very high inflation that subsides before too much debt rolls and interest rates can compensate. The Fed’s capacity to engineer different levels of inflation for finite periods of time is hardly so precise. For the immediate future, it’s unclear that the Fed can generate substantial inflation until money starts moving. Even if it can, investors will not suffer being played for fools repeatedly. For the holders of debt on the losing end of the inflation strategy, the Fed’s loss of credibility would require higher yields even after prices stabilized.

That’s a heavy burden for the future, even if our past extravagance feels lighter.
dsc@chandan.com

Sam Chandan, Ph.D., is president and chief economist of Chandan Economics and an adjunct professor at the Wharton School.