Inflation: Who Wins, Who Loses?

By Lawrence Yun, NAR Chief Economist

Inflation is a stealth tax. You have less purchasing power when it is high.

However, if someone is paying higher prices, then someone on the other side must be receiving higher revenues. Many salary adjustments are based on the consumer price index, and entrepreneurs and businesses receive higher revenue. Mentally, though, people believe the rise in income is from hard work while the rise in consumer prices just eats into that hard-earned income. Therefore, inflation is awful.

Economists do not like inflation for other reasons. Large movements in prices distort price signals and lead to less efficient allocation of resources. Lower productivity growth holds back the country's economic potential and standard of living. As a matter of fact, today's front page story in the Wall Street Journal is entitled: "Inflation, Spanning Globe, is Set to Reach Decade High."

Related to the real estate sector, inflation produces distinct winners and losers.

Homeowners Win

Rising inflation — other things being equal — raises people's income and their home prices. The increases would be nominal terms or what you actually receive in paychecks and the listing price you would set to sell your home. We are not in normal times, however; along with very high housing inventory, we have a condition of CPI inflation and income rising by 3 to 4 percent while home prices are falling in many local markets. But the concept is that if inflation was to get out of hand and rise by 10 percent, then the higher associated income will help home prices recover in nominal terms — though not necessarily in real inflation adjusted terms.

Improving home prices from rising CPI inflation will in general protect homeowners' housing equity. Inflation, however, will help reduce the mortgage burden. Fixed rate mortgages are most prevalent. That means, the vast number of homeowners have fixed mortgage monthly payments. Higher income but fixed mortgage payments is a winning combination for homeowners.

Consider a typical U.S. homeowner in 1970 — when inflation was just picking up. She would have purchased a typical home for $23,000 (this is not a misprint). By 1980, the typical home price reached $62,200. Family income grew from $9,800 (also not a misprint) in 1970 to $21,000 by 1980.

While home prices and income grew, the monthly mortgage payment would have been fixed at $160 per month (assuming $23,000 mortgage at 7.5 percent interest rate). While the homeowner was undoubtedly angry about rising food prices, energy prices, and every other price back in the 1970s, she was not complaining about the mortgage payment.

Homebuyers Lose

If the homeowner was paying back relatively low mortgage payments, then the banks and lenders must have been maddeningly frustrated. But what could the lenders do? Contracts are contracts and both parties agreed to the mortgage terms.

Not to be burned again, the lenders will rightly want to compensate for inflation before lending again. Mortgage rates — no surprise here — rose and rose. The average 30-year fixed mortgage rate rose from 7 percent in 1970 to 14 percent by 1980. It increased further, hitting a peak at 18.5 percent in October 1981. At such a rate, to lower the principal balance by just 10 percent, it would have taken 18 years.

At such high interest rates, who would want to buy a home? Home sales, not surprisingly, fell big time. Home sales activity was essentially cut in half.

Lessons

The current inflation rate is not very high but uncomfortable. CPI has been rising at better than 4 percent over the past 12 months. That is well above the Fed's comfort zone of about 2.0 to 2.5 percent preferred inflation rate. The current economic weakness will likely help moderate inflation going forward. But the weak dollar, high commodity prices, and elevated gold price all signal inflationary concerns. Once out, inflation is hard to put back other than by sharply raising interest rates purposely causing an economic recession as Paul Volker did in the early 1980s.

The Federal Reserve has already cut the Fed funds rate deeply. The 30-year mortgage rates have barely budged, however, given the lenders concern over inflation. It is easily possible for the mortgage rate to rise if the Fed cuts its Fed fund rate further and the lenders want to compensate for inflationary risk. It is questionable on additional efficacy of any further short-term rate cut by the Fed.

I believe there are plenty of monetary stimuli already in the system. What is needed to lift the housing market is fiscal stimulus. The temporary homebuyer tax credit being debated in the House of Representative to purchase any homes (and not just foreclosed homes as is in the Senate proposal) is the appropriate medicine at this time — not only to the housing market, but for the broader economy.

This is one in a series of commentaries by the Research staff of the National Association of REALTORS®. Read more commentaries >

Comments? Questions? E-mail NAR Research.

NAR members, learn how you can add this commentary to your Web site, blog, or newsletter. Read more >