Signs of Inflation

Even as measures of economic growth have slowed, inflationary pressures have been rising in the United States. According to the Bureau of Labor Statistics’ latest report, released last Wednesday, the consumer price index (CPI) has jumped 3.9 percent over the twelve months ending September 2011. Most of that increase can be attributed to higher food and energy prices, which have increased by 4.7 percent and 19.3 percent, respectively. Electricity prices have been fairly stable but gas and fuel oil have increased in price by roughly a third.

While price increases have been dominated by food and energy, which are excluded from core CPI calculations, inflationary pressures are observable in the latter measure, as well. Core CPI inflation has been rising at a steady pace since the end of 2010 and is up 2.0 percent as of September. The core personal consumption expenditure (PCE) index, the Fed’s preferred measure of inflation, has tracked the increase in the CPI, rising from less than 1.0 percent in late 2010 to just under 1.7 percent as of August. The Fed’s mandate-consistent upper bound on inflation is generally understood as 2.0 percent.

The increase in domestic inflation lags trends reported by many of our largest trading partners. Canada’s core inflation measure hit 2.2 percent in September, up from 1.9 percent the month before, in part because of higher clothing prices and rising tuition levels at colleges and universities. In the UK, headline inflation hit a worrisome 5.2 percent in September, propelled by gas and electricity prices and a sharp increase in the sales tax. Given that growth in the UK is weaker than in the US, the Bank of England may tolerate some period of price instability.

Some market indicators show that investors are expecting inflationary pressures to rise over the next several years, even if the near-term outlook appears manageable. That is consistent with an economic forecast where growth improves slowly and the velocity of the money supply – which has expanded rapidly – accelerates. A subset of policymakers is voicing concerns about the inflation outlook, as well. During comments last week, Minneapolis Fed Chairman noted,

… adding accommodation increases the risk of generating inflation markedly higher than the Committee’s objective of 2 percent for a significant period of time … the fourth quarter is not yet complete, but it looks like fourth-quarter-over-fourth-quarter PCE core inflation in 2011 will be around 1.9 percent. I expect it to rise over the next couple of years to slightly above 2 percent.

Should inflationary pressures rise even further, stabilized properties (located in markets that are also generally stable) should see costs passed onto tenants. The apartment sector is best positioned in this regard. But if inflation picks up before occupancy rates rise – as will inevitably be the case in some markets – the inflation hedge will be less effective. In either scenario, the increase in inflation implies an eventual tightening of monetary policy and higher refinancing costs than prevail in today’s commercial real estate market.