Economist’s View: Inevitable Inflation
- Aug 23, 2011
Growth of M1 — the money supply in circulation — in the United States (and most of the world) has seen double-digit, year-over-year growth for the first six months of 2011. Add this to the fact that banks hold about $1 trillion in excess reserves while the federal government is running a budget deficit well in excess of 11 percent of GDP, and the economy is ripe for huge inflation. As the battle between fear and greed has begun to tilt in favor of greed, cash balances have fallen and bank lending has increased.
Inflation is not only inevitable; it is here! Given the level of excess reserves, the banking system possesses the staggering capacity to lend approximately $7.3 trillion, or roughly half of U.S. GDP. Banks are beginning to loosen lending standards, though from extremely tight levels. They are once again paying loan production bonuses, and 25 CMBS shops have been created almost overnight, with an aggregate target of $50 billion in loan production.
As inflation takes hold, generations that have never witnessed it may be surprised by its destructive power. Inflation is a tax on cash holdings and fixed-income streams. It takes wealth from fixed-rate, long-term lenders and transfers it to the federal government to cover budget deficits. As a byproduct, it also helps private long-term, fixed-rate borrowers. It crushes those who have invested their life savings in nominal assets like bonds, particularly those who have bought U.S. government bonds in recent years at record-low yields, paying them below-market interest rates and in debased dollars. It favors spendthrifts (most particularly the federal government) over savers. It favors those with the foresight to index their contracts with inflation pass-throughs, versus those who find such contracts too cumbersome. It favors those with short-term leases relative to those with long-term fixed-rate leases.
It is essential that you are aware of the damage that inflation can wreak on your net investment position. Now is the time to lock in long-term debt, and to do so for as long as you possibly can. In fact, the greatest window of opportunity has already passed, as 10-year Treasury yields have risen from a low of 2.5 percent in October 2010 to 3.1 percent today. Those who locked their rates three quarters ago have created an asset out of their liabilities. And this will only grow over time.
Playing the yield curve is a fool’s game for real estate owners. People invariably believe that they will be able to switch perfectly from short-rate debt to long-rate debt, benefiting from artificially low interest rates in the meantime. The only reason to play the yield curve today is if your cash flow is insufficient to cover a long-term, fixed-interest-rate loan. But anyone who can cover debt service based on long rates today is wise to lock long. This not only takes advantage of today’s low rates but also avoids the risk of capital market disarray when short-term loans mature.
There are two threats of future capital market disarray: the market’s inability to adjust smoothly to rapidly rising inflation and the maturity of the large pool of CMBS and corporate loans put in place in 2005-2007. Such phenomena should theoretically be easily handled, but the reality is often different. Remember: Playing the yield curve works wonderfully—right until it does not.
Dr. Peter Linneman is principal of Linneman Associates and Professor Emeritus at the Wharton School of Business at the University of Pennsylvania.