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A Decade in Flux: What's Inflation Good For?


Economics can't even agree on a definition for the term.

This post first appeared in the Special Edition: Cirios Trends: A Decade in Flux. For the first article in this series, click here. For the second article, click here. Keep an eye open for more of the same, coming later this week.

Inflation: What Is It Good For?

At the heart of some of the most contentious debates in the otherwise drab world of macroeconomic theory is that of inflation (yes, there are in fact contentious debates about macroeconomic theory). To wit, economics can't even agree on a definition for the term.

The laymen understanding of inflation is the rising of prices. Some economists agree, while another camp argues that higher prices are merely one of many signs of inflation, which they define as an increase in the supply of money within an economy.

Commonly, inflation is measured by the Consumer Price Index, or CPI, which purports to be a representative basket of goods and services that reflects what the average consumer buys with his or her hard-earned dollars. And while there are myriad criticism of the CPI and how government bean counters arrive at the final tally, that's a debate for another forum.

Suffice to say, as can be clearly seen below, prices in the US have been steadily rising for about as long as anyone can remember. And as some generations remember better than others, during the 1970s and 1980s, prices rose rapidly indeed.

Most credit then-Federal Reserve Chairman Paul Volcker (currently the chairman of President Obama's Economic Recovery Advisory Board) for breaking the back of inflation in the early 1980s with a hard-line policy of high interest rates. High borrowing rates discourage investment, curtailing economic growth, which can slow the pace of rising prices. This politically unpopular monetary policy led to persistently high unemployment and a deep recession, but ultimately inflation was brought under control.

Since Volcker's tenure as Chairman, successive Fed Chairmen have kept interest rates low, while presiding over a period of slowly rising prices. While this sounds like a perfectly healthy economic balance, many argue this "balance" fostered the eventual imbalances that threw the global financial system into such wild disarray.

Inflation and Home Prices: Is the Romance Over?

A cursory look at the long term trends for inflation and home prices reveal strikingly similar patterns. Until, that is, right around 2003 (see dotted line below).

In the wake of the short recession caused by the dot-com bust and September 11 terrorist attacks, then-Federal Reserve Chairman Alan Greenspan aggressively lowered interest rates to spur economic growth. Leaving rates at historic lows for several years encouraged active borrowing, helping to bring the US economy out of its tailspin.

Greenspan critics now wonder, at what cost?

As homeowners, real estate speculators, investment bankers, mortgage brokers, real estate agents, appraisers and credit rating companies (among others) rushed to grab their piece of property values, the historic relationship between moderate inflation and steadily rising home prices broke down. Home prices leapt, while inflation continued its casual march upward.

Then, around the beginning of 2007 (the "peak" of our six-month moving average dataset), the relationship flipped inverse (see arrow above). Rising prices as measured by the CPI faced off with tumbling home prices, feeding the feverish macroeconomic debate of inflationists versus deflationists.

Now, as what feels like the entirety of the financial world awaits the inevitable inflation that "must" come after trillions upon trillions of dollars in economic stimulus, we hope the following few pages shed some light on what we can expect if it turns out the majority (in this case, the inflationists) prove to be correct. Since policy-makers' key tool to fight inflation is higher interest rates, and higher interest rates translate into more expensive mortgages, future inflation has serious implications for real estate markets around the country.
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