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The year-over-year inflation rate for the month of July dipped down to 8.5% following its peak of 9.1% in June. This is strong evidence that the policy of the Fed, the changing global landscape, or a combination of both, is bringing prices back down. Our worst fears of hyperinflation and a runaway year-over-year rate have been squelched, but it is still not clear that 2% is an achievable inflation target.
Chairman Jerome Powell made his annual speech at Jackson Hole on the structure of the economy and the goals of the Fed moving forward. In this speech, Chair Powell reiterated his 2% inflation goal and took a hawkish stance that, “there is clearly a job to do in moderating demand to better align with supply.” In other words, our demand for goods and services is so strong that the global economy cannot keep up with our demand which is why prices are going up, and the Fed needs to reduce the demand in order to maintain price stability.
The problem is that much of this inflation is not interest rate sensitive. Increasing the price of debt will not fix the supply chain, nor will it end Russia’s invasion of Ukraine. Many economists now believe that the days of 2% year-over-year inflation are over and we need to think about what it means to live in a world where supply is less consistent and inflation is a bit higher, so let’s do just that.
Before we go further, it is important to point out that an inflation rate of 2% is a very recent phenomenon, especially as an explicit target. 2% is not a magical number. There was no scientific process used to determine this rate, and there was no council of experts to derive the ideal amount of inflation either. The 2% target was essentially pulled out of thin air in the 90s. New Zealand was the first country to adopt any inflation target at all after their finance minister made an off-handed comment about the ideal inflation rate being between 0 and 1%.
Of course, many of you will be familiar with how the story plays out from here. Ben Bernanke set 2% as the explicit, publicly stated goal in 2012 and confirming that the Federal Reserve had been targeting this rate since at least 1996. As always, it is very easy to criticize the Fed for their policy, but this very policy led us through decades of prosperity and relative stability. We are just learning now that the predictability was unsustainable.
All that being said, there is something fascinating about this 2% figure that we have been married to for decades. Not only does a small amount of inflation have its benefits, but it protects against deflation. Long time readers of our newsletter might recall that in our April addition, we considered a world without inflation. It turns out that a world without inflation is a world of hoarding currency and mercantilist thinking. The fact that there is no set amount of US dollars in the world means that wealth must circulate the economy to maintain and generate more wealth. If transactions are not made, then wealth is diluted at the inflation rate: 2% a year.
So a higher inflation rate might dilute that money out quicker and incentivize even more transactions, right? Well, one part of this equation that we did not cover in that April newsletter is the fact that inflation squeezes the consumer. Living expenses growing by a small percentage each year means that upward mobility isn’t just a dream, it is a necessity.
So where does this leave real estate and the future of Peak 15? Well one of the underappreciated details of Chair Powell’s speech was the long-term interest rate target of 2.25-2.5%. Chair Powell tells us that over the next several months, the Fed will raise interest rates to squeeze out the remaining inflation in the system, and then interest rates will plunge back down to the present rate once “the job is done”. As for when inflation will be completely squelched, it is difficult to say.
Real estate should be looking forward to a robust environment once the market fully swallows the reality of higher interest rates. We have seen many institutional private equity shops pause investing for the next few months until they have a better grasp on where the market is headed, but we now have a clear path forward laid out by Chair Powell. Remember that the enemy of a good real estate market is not a high interest rate, the enemy of a good market is uncertainty. We believe that once the interest rate reaches its peak (likely 4-4.5%) and the Fed is confident that “the job is done”, markets will stabilize.
We are very proud that our first real estate fund will be launching right at the peak of the interest rate. We expect that the real estate markets will continue to be choppy for the time being as the Fed continues their hike up interest rate mountain, but we expect smooth sailing once these hikes are done. Whether or not the Fed is able to achieve its long-term goal of 2% inflation is not particularly relevant to us at Peak 15. Either they will reach 2% inflation and pause the hikes, or they will realize that 2% is impossible and stop trying. Either way, stability must be achieved and it is that stability that we are looking forward to.
Keep Climbing!
