Rekindling popular concerns that current monetary policy interventions will ultimately foment an uncontrolled rise in inflation, the Federal Open Market Committee announced on Nov. 3 that it would purchase $600 billion in long-term treasury securities by the end of the second quarter of 2011. In choosing to renew a program of quantitative easing–formally, an expansion of the Fed’s balance sheet through the creation of new money that is used in the purchase of the government’s own securities–the voting members of the FOMC are necessarily conceding that the economic recovery remains unusually fragile and that underlying inflation trends are below optimal levels.
It is entirely unclear if quantitative easing will be effective in supporting conditions favorable to enhanced economic growth or the implicit target rate of inflation, even if it results in marginally lower long-term interest rates during the window of bond-buying activity. Business investment is more closely tied to the economic outlook, which remains weak, than to a short-term but supportive shift in borrowing costs. Similarly, the risk of overshooting the inflation target in the near term is understood to be low, though there is considerable slack in real economic activity.
In the long run, however, the risk of heightened inflationary pressure is credible if the Fed does not tighten its current bias. For commercial real estate investors, lenders and operators, the potentiality is of immediate significance given the dynamic relationship between inflation and property performance and the implications of rising inflation for the cost of financing.
Inflation Trends Lower
In contrast with concerns about the potential for a rise in expected inflation or shocks from unexpected inflation, current inflation trends are subdued by historic standards. In fact, the most recently reported measure of core consumer price inflation is at its lowest level on record, since the Bureau of Labor Statistics began tracking the series in 1957. In part, this reflects the large gap between current and potential economic output–a slack in economic activity generally precludes strong inflation. The concern among policy makers now is that inflation is too low, precariously close to the tipping point at which a sustained decline in the prevailing price level might vex monetary policy.
In a Nov. 4 Washington Post op-ed, Chairman Bernanke reminded the readership, which undoubtedly included the leadership of both parties, that there are risks from a decline in price levels. He points out that “… although low inflation is generally good, inflation that is too low can pose risks to the economy–especially when the economy is struggling. In the most extreme case, very low inflation can morph into deflation, which can contribute to long periods of economic stagnation.”
Ideally, quantitative easing will foment inflation, but not too much. In the latter case, policy makers have ample tools at their disposal to sterilize the increase in the money supply. We must understand that these tools have the potential to be costly.
Daniel Thornton, vice president and economic adviser at the St. Louis Fed, wrote about this on Nov. 10: “Given that additional quantitative easing may have only modest effects on economic growth, employment, or inflation and the potential to significantly exacerbate the FOMC’s problems when the time comes to restore its balance sheet to a more normal configuration, it is easy to understand the considerable disagreement about the desirability of such a policy.”
Why Quantitative Easing
Given the risk of a costly unwinding and questions as to the effectiveness of the policy in the short term, why quantitative easing? In a 2004 paper published in the economics profession’s foremost peer-reviewed journal, Chairman Bernanke and Vincent Reinhart addressed the question of monetary policy in a low-interest-rate environment, acknowledging the central fact that “when the short-term policy rate is at or near zero, the conventional means of effecting monetary ease (lowering the target for the policy rate) is no longer feasible.” Years before they could have imagined the exact circumstances that have prompted quantitative easing in the United States, the authors describe just such a program as one of the “strategies for stimulating the economy at an unchanged level of the policy rate.”
There is clearly an element of art as well as science in pursuing these strategies since “… it is also true that policymakers’ inexperience with these alternative measures makes the calibration of policy actions more difficult.” It is in this calibration that reasonable questions arise about unintended consequences of current actions. These concerns are not lost on monetary policy makers, although the balance of the FOMC’s thinking has weighed in favor of action. In his aforementioned column, Chairman Bernanke addresses the issue forthrightly, stating as follows:
“Although asset purchases are relatively unfamiliar as a tool of monetary policy, some concerns about this approach are overstated. Critics have, for example, worried that it will lead to excessive increases in the money supply and ultimately to significant increases in inflation. Our earlier use of this policy approach had little effect on the amount of currency in circulation or on other broad measures of the money supply, such as bank deposits. Nor did it result in higher inflation. We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time.”
Chairman Bernanke would have us proceed without timidity in the conduct of monetary policy. In a speech last Friday at a meeting of the European Central Bank in Frankfurt, he stated that “… the past two years have demonstrated the value of policy flexibility and openness to new approaches … as the global financial system and national economies become increasingly complex and interdependent, novel policy challenges will continue to require innovative policy responses.”
Thomas Hoenig, president of the Kansas City Fed, takes a dissenting view, arguing in an October speech before the National Association of Business Economists that “the FOMC must be mindful of this fact and be cautious in pursuing elusive short-term goals that have unintended and sometimes disruptive effects.”
He went on to question the efficacy of the exit tools, offering that “while I agree that the tools are available to reduce excess reserves when that becomes appropriate, I do not believe that the Federal Reserve, or anyone else, has the foresight to do it at the right time or right speed.”
Will Quantitative Easing Stoke Inflation?
With the decision made, arguments for and against QE2 are now largely academic. The challenge is now in charting the outcomes, both probable and possible. The idea that inflation is related to monetary policy has a long intellectual history. Every undergraduate economics student–whether enrolled at Chicago or the Saltwater Schools in Philadelphia, Cambridge, New Jersey or New Haven–has heard Milton Friedman’s dictum that “inflation is always and everywhere a monetary phenomenon, in the sense that it cannot occur without a more rapid increase in the quantity of money than in output.” If quantitative easing is causally related to a dramatic expansion of the money supply, price instability will necessarily ensue.
Professor Friedman’s explanation of money supply’s role in driving inflation is instructive in our assessment of the QE2’s downside. That is because broad measures of money supply, including credit, are not growing rapidly. Chairman Bernanke made this point in his Nov. 4 apology. The same point was made earlier this year, by then San Francisco Fed President Janet Yellen, who wrote in a March 29 Economic Letter that “… expanding the Fed’s balance sheet has not, in fact, led to a surge in credit. Lending has been quite restrained. Banks have been cautious as they seek to return to financial health, keeping much of the money created by this expansion in their accounts with the Federal Reserve.”
Taking the pragmatist’s position that inflation outcomes are also determined by inflation expectations, Mr. Hoenig questions the consensus view, offering that “the FOMC has never shown itself very good at fine-tuning exercises or in setting and managing inflation and inflation expectations to achieve the desired results.”
The net result is that the outcome is uncertain.
Is Inflation Good or Bad for Real Estate?
The disagreement among leading policy makers on the inflationary impact of quantitative easing behooves us to consider the implications for commercial real estate. Our baseline expectation may be that inflation will remain in check. We cannot, however, ignore the possibility of surprises while in terra incognita.
Conventional wisdom dictates that commercial real estate offers a hedge against inflation. We must be careful what we wish for. The relationship between property performance and inflation is not invariant. Real estate can offer a partial hedge against expected inflation, but it is generally ineffective in hedging unexpected inflation.
Even in the first case, the efficacy of the hedge depends upon operators’ pricing power in the relationship with tenants. If fundamentals are weak, inflation will undermine real returns. As described by Glenn Mueller 20 years ago, “while real estate clearly provides an effective inflation hedge, it does so primarily when the real estate market supply-demand equation is in balance.” Some investors will be concerned with the inflation-hedging effectiveness of public REITs rather than the specifics of property-level performance. Research shows that REIT returns generally decline in inflation. The equity component of REITs plays a role in this result.
As showed by Eugene Fama almost 50 years ago in his famed treatise on Wall Street’s random walk, there is a negative relationship between stock returns and inflation, generally considered a proxy effect that captures the negative impact of higher inflation and higher interest rates on macroeconomic performance.
The REIT findings hold years later. Joe Gyourko and Peter Linneman find that “REIT returns tend to be strongly negatively correlated with inflation. In this respect, they look more like traditional stocks and bonds than any other type of real estate.”
Ultimately, the investor who anticipates a slow return to job creation or who might opt to seek safe haven in REITs, instead of properties, should wary of inflation’s specter.
Sam Chandan, Ph.D., is global chief economist and executive vice president of Real Capital Analytics and an adjunct professor of real estate at Wharton.