Review of all things Real Estate: Inflation, mortgage interest rates and home prices, oh my!

This will be a 2-3 part article dealing with the interrelationship of the subjects in the title line. All of these factors contribute to the high price of housing and yet puzzling, despite mortgage interest rates having reached 22 year highs, buyer demand for home purchases is still remarkably strong.

Let’s address the subject of inflation first; what it is and what causes it.

Inflation is the general rise in the prices of goods and services over time, which erodes the purchasing power of consumers (remember when Coke was a nickel?).

The main causes of inflation are excess demand or decline in supply of goods; too many dollars chasing too few goods and services. This can be due to factors including increase in wages, increase in the price of raw materials, increase in taxes, decline in productivity, public spending, tax reductions, rising prices in international markets, and/ or increases in the supply of money.

These factors can shift the aggregate demand or supply curves, leading to higher prices. Inflation expectations can also influence inflation by affecting the behavior of consumers and producers.

Consequences of inflation include the reduction of the real value of money and savings. This means that people who hold cash or fixed-income assets, such as bonds, will see their purchasing power decline as inflation erodes the value of their money. This can discourage saving and encourage spending, which will stimulate the economy in the short term but also create more inflationary pressure in the long term.

Inflation can increase the cost of production and borrowing. When prices rise, producers and businesses must pay more for their inputs such as raw materials, labor, transportation and energy. This can reduce their profits and force rises in prices to cover their costs.

Higher prices can also reduce the demand for their products, especially if consumers are sensitive to price changes. Additionally, inflation can increase the interest rates that lenders charge to borrowers which makes borrowing more expensive and reduces investment and consumption.

Inflation distorts relative prices and economic signals because when inflation is uneven across different sectors or regions of the economy, it can create price distortions that affect the allocation of resources and the efficiency of markets.

As an example, if inflation is higher in one industry than another, it can make the products of that industry seem more expensive and less competitive than they are. This can lead to overproduction or underproduction of certain goods and services and could create market inefficiencies; or even failures.

Inflation can affect income distribution and social welfare due to uneven impacts on different groups of people depending on their income sources, spending patterns, and assets. Generally, inflation tends to benefit debtors and hurt creditors because debtors can repay their loans with less valuable money while creditors receive less valuable money in the payoff.

Inflation also tends to benefit those who have flexible incomes that can adjust to price changes such as wage earners who can negotiate for higher wages or business owners who can raise their prices. On the contrary, inflation tends to hurt those who have fixed incomes that do not adjust to price changes such as pensioners or salaried workers who have no bargaining power.

Also, inflation can increase inequality and poverty since lower-income households tend to spend a larger percentage of their income on necessities that are more affected by inflation, such as food, shelter, and energy.

Inflation can certainly influence economic growth and stability. A moderate level of inflation is often viewed as beneficial for economic growth since it can encourage consumption, investment, innovation, and productivity. A low and stable inflation rate enhances confidence and certainty among consumers and producers which can then foster long-term planning and economic development.

Conversely, a high or volatile inflation rate can be harmful for economic growth since it reduces the real returns on investment, discourages saving and capital formation, distorts resource allocation and market signals, creates uncertainty and risk aversion among consumers and producers, and undermines the credibility and effectiveness of monetary policy.

Inflation is a complex phenomenon that has widely reaching effects on the economy. Some effects can be viewed as positive while others are negative, therefore, understanding the causes and consequences; good and bad, of inflation is essential for making sound economic decisions.

With this article as a stage setter, in the next few weeks we will examine decisions and actions taken primarily by our government that have resulted in the high cost of housing across our entire country, but especially here in California.