Thursday, May 18, 2006

Inflation woes

One of the great mysteries of the last few years is where has inflation been? The government has racked up large deficits and grown future entitlements, demand for debt has been voracious, and housing prices have been shooting up. But inflation remained tame and interest rates low.

Inflation is calculated by pricing a bundle of goods and services, and it includes rent but not purchase price of housing. This is because owning a house is a mixture of investment (house might appreciate) and consumption (I need a roof over my head) and inflation should be focused on consumption costs. One weird side effect of the housing bubble is that rents have actually been flat to declining in some markets where prices are going through the roof (such as Boston) as people ditch renting to climb aboard the real estate rocket. It seems that this has stopped, and rents are beginning to creep upwards again, which increases the inflation measurement, and suggests that the Fed will continue to raise rates.

In the past, high inflation has been good for borrowers because it erodes away the value of their debt. This is why governments with large deficits invite inflation -- it's a way for them to make their real interest payment obligations lower. But this time, many borrowers have taken out option ARMs where the rate they pay will adjust upwards if interest rates rise, meaning that they will not get the full benefit of a high-inflation, high-interest rate environment. Yes, the real cost of their debt will decrease, but their interest payments will go up.

Stocks have also fallen but the last time I checked they were trading well above historic PEs, so the mystery there was more why they remained so expensive, not if they should come down to historic norms.


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