Inflation, Interest Rates, and the Housing Crisis
The American people have a love-hate relationship with inflation
They hate inflation but love everything that causes it
William E. Simon
The inflation rate target of the US Federal Reserve and the Bank of England is 2%, with most high-income countries having similar targets. The logic behind this is that if inflation drops below 2% there is a danger prices may start to fall, leading to consumers delaying purchases, and thus a slowing economy. Whereas a small but significant inflation rate deters people from hoarding money, and encourages investment and economic activity.
The arguments against a higher inflation target are that real incomes will decline if income growth is less than inflation; that savings will be eroded if the interest rate on deposits is less than the inflation rate; and that it creates ‘business uncertainty’, making it difficult for businesses to plan investments. If you have your thinking cap on, you should realise that these excuses are all pretty thin.
An inflation rate of 3-5% can easily be adjusted for, in the same way that a 2% rate can. And as long as the rate is maintained within a narrow band businesses can still plan ahead. A 3-5% inflation rate allows for flexibility, and can help to buffer fluctuations in the market. It also allows for a healthy level of demand, whereas trying to maintain a rate of 2% often requires undue suppression of demand, leading to economic stagnation.
When inflation is controlled by adjusting interest rates economic stagnation can lead to extremely low rates over an extended period. The low interest rates mean people on low and moderate incomes can borrow more than they would otherwise, which can in turn allow house prices to reach levels that would otherwise have been unaffordable for them, something we have seen over the last couple decades.
Anyone listening to economists today would get the impression inflation is a dirty word. And while it is true that if inflation gets out of hand it can be very disruptive to the economy, if it is well controlled it can be a useful tool to adjust economic factors that are out of sync.
For example, if your housing industry has been allowed to reach crisis levels, where accommodation is unaffordable for many people, then maintaining an inflation rate of 3-5% for a few years could be the best way to correct it.
To be deemed affordable, median house prices should be no more than three times the median household income. In many developed countries the median house price is more than six times the median wage, and to get housing prices down to affordable levels prices would need to be reduced by around 50%.1
With any other commodity the answer would be to increase supply, and if the market was functioning as it should this would happen naturally. Increasing supply of housing can be difficult though, and even when it can be done, building a house takes a long time. Nor does supply and demand theory always apply to the housing industry, and often the reverse occurs.
When supply is short and prices start to rise, those who are thinking of selling will hold off putting their house up for sale, and instead wait until prices stabilise, so supply dries up rather than increases. Meanwhile, people who are thinking of buying jump into the market, and try to buy before prices get out of their reach, which drives prices up even further.
If prices start to fall, however, buyers will stop buying and more sellers may enter the market. This can be a serious problem if house prices drop below the value of the mortgages held against them, because homeowners will be financially better off if they default on their loans and let the bank foreclose rather than sell. This was the situation in the US in the mid-2000s, and it led to the global financial crisis. So, how do we bring down median house prices by up to 50% to achieve affordable levels without the risk of triggering a collapse of the financial industry?
The answer is we don’t; we raise the median wage instead. Doing this will lead to inflation, but if inflation and wages are linked real wages will stay the same. This only works if we can keep house prices stable, which won’t be easy. If there is a shortage in supply then this must be addressed first. If the reason for a lack of supply is a loss of housing stock due to long-term accommodation being converted to short-term holiday lets then aggressive regulations may be called for. If it is due to congestion in the building industry then that must be dealt with too, be it due to a lack of resources or over regulation.
Indexing all incomes to the inflation rate can be problematic, since it can lead to runaway inflation. We don’t need to increase everyone’s income though; just those earning up to the median wage. Those earning more than the median wage but less that the average wage should get a partial increase in income, but if someone is earning more than the average wage they shouldn’t need a pay increase to afford decent housing. And if they feel they deserve one, then they can take it up with their employer.
This would have the added advantage of reducing income inequality, so it would be a win/win situation from a societal point of view. The rich won’t like it though, and they control the government and the media, and therefore the public narrative, which is why we have been convinced that inflation is bad.