Interest Rates, Inflation and the Markets

The current investment markets are in a battle between interest rates and inflation. Let me see if I can explain it a bit by starting in the 1980’s when I financed my first home with an 18% loan.
No, that is not a misprint. I laugh at today’s young home buyers who worry about 30 year mortgages approaching 4%. A year after buying my home I refinanced it at 12% and felt like I had robbed the bank. For most people the cost of a home is the monthly payment, not the sticker price. Despite the high interest I was able to obtain a reasonable monthly payment because the home price was so low. I never intended on paying that loan for 30 years and when the real estate market rebounded following lower interest rates, I was able to realize a nice profit.

Today interest rates are very low which allows people to pay much more for a home. Low rates also encourage people to buy for fear they might miss out. Factor in supply and labor issues and we have a recipe for a real estate market that is almost out of control. All this could change very quickly if interest rates go up, reducing the price buyers are able to pay.

Low interest is one factor that is driving up real estate prices and it has been doing the same to stocks. Businesses can grow much faster if they can borrow cheap money, but raise the rates and things can slow down in a hurry.

Now let’s consider inflation. One of my favorite economists, Brian Wesbury, gives the following simple explanation of inflation. “If the entire economy consists of 10 apples and 10 dollars, then each apple will cost a dollar. If the government prints 4 more dollars so there are now 14, each apple will cost $1.40.” The apples don’t get more valuable. The dollars you are buying them with become less valuable.

As the government prints new money they push up prices. The latest report shows inflation hit 7% in December. That means if an apple costs a dollar today, then it will cost $1.07 a year from now. If a person is earning 2% interest in their savings account, then todays dollar will only be $1.02 in a year and they will no longer be able to buy that apple. They might as well buy their apples today.
And that is what home buyers and investors have been doing. They are buying partly to keep up with inflation, and partly to try and profit from it. And in the process the buying spree has created even more inflation.

So for investors, when does the party end? If interest rates go up enough to reduce demand, it will tamp down inflation in the process, and the profit takers will start selling. That is largely why the stock market has been unstable this past month, and why real estate prices may be next. After several great years, investors might want to consider taking a more conservative position for a while.