Relax, Inflation Is Not A Problem (But It’s Also Not Your Friend)

Worried by inflation? With the U.S. consumer price index rising rapidly to 5% growth and UK rates now over 2% and still growing, inflation seems to be back after a 20-year break.

There is global pressure to push up interest rates in an effort to curb inflation growth. 

Yet according to AEW Head of Research Hans Vrensen, inflation is a blip, not a bubble, and will soon be gone. Commercial real estate doesn't need to fret, he said. These are his reasons.

1. We’re All Getting Old

The older a country’s population, the less likely inflation is to be a serious problem. If the birth rate is also in decline, the effect is magnified (look at Japan).

Why? As we live longer, we need to save more for a longer retirement, and the more we save, the slower the velocity of the circulation of money. That means less inflation.

Longer life probably means a longer period needing social care and support, and with government providing relatively limited funding for social care, that implies even more saving or asset depletion by elderly people.

Add all that up together, and an older population locks up a lot of wealth that would otherwise be circulating rapidly and increasing inflation risk.

2. Globalisation Keeps Prices Down

The data is clear: The past 30 years of increased globalisation has kept prices low. Every protectionist event — such as President Donald Trump’s trade war with China — demonstrably pushes prices up.

AEW assumes that global trade is resuming a pre-pandemic pattern and that the super-complex supply chains that create additional problems are, thanks to normal market pressures, removed or simplified.

So long as we stay global, inflation risk is mitigated.

3. Covid-19 Did Us A Favour

The coronavirus pandemic created an unprecedentedly large output gap, meaning economic capacity exceeds economic output. The gap is widest in the UK where Oxford Economics and AEW reckon it approaches 5%, and it will remain negative throughout Europe until 2023.

The consequence is that as the economy picks up speed, the usual risk that it rapidly hits capacity constraints and causes prices to rise does not apply. Or at least does not apply either quickly or evenly. Whichever of those alternatives turns out to be the case, the good news is that there’s some slack and it means inflation risks are a little lower.

4. Bond Yields Don’t Bounce

This is one for the specialists and it goes like this: Government bond yields and inflation have a strong correlation in Europe. Inflation goes up, and so do government bond yields. Since 1981, bond yields have been a good proxy for inflation because bonds fund government debt and lots of government borrowing is inflationary. 

Lately, though inflation has gone up, bond yields haven’t. This is more common in the U.S., and analysts are now noticing the trend on the other side of the Atlantic.

AEW says that, assuming the old bond/inflation link is as strong as ever, the two have to come back into alignment, which suggests inflation will shoot down to join bond yields.

Though AEW concludes inflation isn’t the tiger it seems, neither is it a pussycat or something to get complacent about. That is because the common assumption that inflation is a friend to property (because capital values are maintained) is probably wrong.

AEW picks its words with care, pointing out that inflation and capital value appreciation are uncorrelated, noting that if you have an index-linked income then inflation isn’t so much of a worry. Then it adds: “Based on our limited data, it is difficult to confirm that real estate, in respect of capital appreciation, is a good inflation hedge.”