Today we will continue our series on the economic drivers of our residential housing industry (We have already covered GDP and Unemployment). In this blog post, we’re going to demystify an economic fundamental that has a significant influence on the real estate market: inflation. This has been a topic that’s been dominating conversations in government circles, the media, Wall Street, and Main Street over the last 18 months or so. But why should you, as a Realtor, care about inflation? Simply put, understanding how inflation works can equip you with the tools to communicate more effectively with your clients and stay ahead in the industry.

What is Inflation?

At its core, inflation is best described as an increase in prices. An increase in prices naturally results in decreased purchasing power for your money. Inflation can be a self-fulfilling prophecy. If consumers are concerned that prices increase from inflation, more consumers buy a product sooner. That creates additional short-term demand, which will push prices up even more. 

But that doesn’t mean that inflation is inherently bad. In fact, some level of inflation is seen by the Federal Government as good and even representative of and critical to a healthy economy. But like many things, balance is key.

The Fine Balance of Inflation

The sweet spot for inflation, as decided upon by Western economies, is around 2% per year. This seemingly arbitrary number was initially adopted by the New Zealand government back in the 1980’s and has since been generally globally accepted. 

Why 2%? Well, no one really knows. The consensus is that this rate is just right – it’s not too high to cause economic instability, and it’s not too low to stall economic growth.

You might be asking yourself, why is any inflation considered good? There are a couple of reasons for this. One of the key reasons is that mild inflation can make it easier for a government to repay its debts. As prices for goods, services, and wages grow slightly and more tax revenue is collected, it becomes less burdensome for the government to pay back what it owes. For the average consumer, a little inflation is representative of a healthy economy that is experiencing moderate growth. Wage earners’ incomes typically grow with a growing economy. 

When Does Inflation Become a Problem?

As with many things, too much of a good thing can be a bad thing, and this is true with inflation too. Inflation that significantly surpasses the 2% target is generally perceived as bad for a couple of reasons.

First, when inflation rises, the purchasing power of consumers diminishes. The money they earn simply doesn’t stretch as far, so they buy less. This is especially harmful to individuals and families living paycheck to paycheck. Too much inflation too soon will therefore reduce consumer spending. And the American economy is grounded in consumer spending – it is the backbone of our economy! If you crimp the average consumer’s spending habits, economic contraction will shortly follow, which can result in a negative GDP. 

High inflation can amplify social inequality. The gap between those with resources and those without widens, fostering social discord – a situation that no government wishes to face.

Inflation can also be self-perpetuating. When people anticipate higher prices in the future, they’re likely to buy more now, depleting inventories and inadvertently driving prices up further. This can quickly become a pretty nasty cycle that can become hard to break. 

Controlling Inflation

Given the potential harms of high inflation, governments naturally want to rein it in swiftly. One of the primary tools for doing this is by raising the federal funds rate, an aspect of economic policy managed by the Federal Reserve System. 

But that’s a topic for another day. For now, you as a Realtor, have a grasp on the basics of inflation, how it arises, and its potential impacts. In our next discussion, we’ll delve into how inflation specifically affects mortgage rates, a subject of direct relevance to your work in the real estate industry.

So, until then, use this knowledge to enrich your conversations with clients and colleagues. After all, real estate isn’t just about properties – it’s also about understanding the economic forces that shape the market. See you in a week!