Unprecedented money in the system leads to unprecedented prices. This leads us to expect cap rates to fall over the coming years as the Federal Reserve allows its vast monetary injections to leach into asset lending. We expect a repeat of the asset price inflation we witnessed from 2013 to 2019, when the injections from QE1-3 fueled asset lending. It was not a random occurrence that valuation multiples expanded, and cap rates fell over these years. Rather, these effects were due to the unprecedented amounts of money created by the Fed chasing assets.
Inflation continues to occur, partly for anomalous reasons reflecting abnormally low prices in 2020 (e.g., hotel rates, airline fares, used car prices and to a large degree the price of oil). Today’s inflation simply reflects a normalization back toward 2019 price levels and as such, the large percentage increases are statistical anomalies. Stated differently, consumer price inflation today is not primarily monetary inflation. Instead, it reflects the myriad imbalances of supply and demand caused by the shutdown and the subsequent recovery.
Capacity was cut across the world in 2020 as firms hoarded cash in the face of pandemic panic, and governmental interventions restricted production, consumption and transportation. This has resulted in many instances where the recovery of supply has notably lagged the recovery in demand, generating price spikes for goods with relatively inelastic demand (e.g., housing and computer chips). These spikes are market, not statistical anomalies, and are identified by new all-time highs in real prices.
Monetary policy is the wrong tool to address the supply-demand imbalances created by non-monetary phenomena such as hurricanes, floods, tornadoes and shutting down the economy. For example, reducing the rate of monetary expansion will not get the ships anchored off the Port of Los Angeles unloaded faster or increase the supply of computer chips. Today’s continuing supply issues reflect the cost of shutting down the world economy. An economy is not so easily restarted and subject to the “weakest link.”
Until capacity catches up with demand, prices will remain high by historical standards. However, they will moderate over time—as it happened with lumber over the past year. Thus, while these prices may remain high for 12 to 24 months, they will contribute little to inflation by the third quarter of 2022. Only if demand growth notably exceeds supply growth over the next year will these prices go even higher—though they may remain well above 2019 levels. In fact, in many cases, the prices of these items will mute as their prices fall back toward 2019 levels. Remember that rising—not high—prices are inflation. Thus, abnormally high prices will be deflationary as they return to historical norms. Remind yourself that NBA players are tall but not growing, while children are short and growing.
Excerpt from The Linneman Letter, Winter 2021-2022.
Dr. Peter Linneman is a Principal & Founder of Linneman Associates and Professor Emeritus at the Wharton School of Business, University of Pennsylvania. www.linnemanassociates.com
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