Stagflation is the worst of all economic worlds -- one in which inflation is high, while gross domestic product growth is sluggish. That state of affairs prevailed at times during the 1970s, when big shocks to the economy ignited inflation and the Federal Reserve attempted to bring it back into check without strangling growth. While the parallels between 2022 and the 1970s aren't all that great, they do offer some interesting takeaways.
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The Fed is raising interest rates to slow inflation
At its March meeting, the Federal Open Market Committee (FOMC) agreed, as expected, to increase the federal funds rate by 25 basis points (or one quarter of 1%). It now sits in the range of 0.25% to 0.5%. The FOMC will meet six more times in 2022, and said after the March meeting that it expects to boost that benchmark interest rate again after each of them. As such, it forecasts that the federal fund rate will end the year somewhere in the neighborhood of 1.75% to 2.25%. Historically speaking, that's a pretty aggressive pattern of rate hikes. And reflecting that, the Fed dialed back its estimate for 2022 gross domestic product growth from 4.1% to 2.8%, and raised its annual inflation rate estimate to 4.1%.
Again historically, 2.8% is a pretty solid growth rate for the U.S. economy, and the Fed's forecast for unemployment remained at 3.5%, which is very robust. This means the Fed isn't predicting anything close to stagflation. But what would happen if the Fed's moves against inflation proved to be too aggressive, and choked off growth without stemming inflation?
Rising construction costs make new homes more expensive
If that happened, commodity prices for things like energy, food, and building materials would keep increasing significantly in price, which would raise the cost of new construction. It is important to understand that the inflation indices are all constructed using different methodologies. The Federal Reserve prefers to use the Personal Consumption Index, which is different than the consumer price index that the business press more commonly references. These indices basically weigh a basket of goods and then use all sorts of adjustments to come up with a modeled number to describe inflation. This means that increases in individual goods may or may not be increasing at the rate of the inflation index. According to the National Association of Homebuilders, prices for building materials have risen 20% over the past 12 months, and are up 31% since January 2020.
Higher construction costs would exacerbate the affordability issues that already exist in the housing market. Home prices nationally have been rising at a high-teens clip year over year for the past year due to record-low numbers of homes for sale. Further inflation would only make this worse. In addition, first-time homebuyers are competing with large rental companies that specialize in single-family homes such as American Homes 4 Rent (AMH +0.06%), which are buyers of single-family properties as well.
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Key Data Points
Institutional money is crowding out first-time homebuyers
If stagflation appears, the first big effect it will have on the housing market will be that the typical first-time homebuyer will struggle even more to compete with institutional buyers in their search for one of a meager supply of homes for sale. Institutions are getting mid-single-digit percentage yields on rentals, along with mid-teens percentage home price appreciation. That dwarfs the returns available from other asset classes such as corporate bonds, Treasuries, or even equities these days.
The second effect is that people are more likely to struggle to upsize or downsize, especially if they have a fixed-rate mortgage with a lower interest rate than they would be able to get again. More elderly people are choosing to age in place rather than moving somewhere else in retirement. Families looking to move from starter homes to larger homes may find the increased housing expenses more daunting, so in lieu of buying a bigger house, they may choose to improve their current one. That would be good news for home improvement retailers like Home Depot (HD 1.92%).
A trend of rising prices for new and existing homes generally leads to rising rents, too, which would be good news for apartment real estate investment trusts like Equity Residential (EQR +0.98%), which have locked in low-interest rates on their debts in the past two years. As a result, their profit margins should increase.
Overall, the most obvious impacts of stagflation would be felt by first-time homebuyers, who are rapidly getting priced out of the market and will disproportionately feel the pinch of rising interest rates. If wage increases keep pace with inflation, then these folks should be no worse off than they are now. But in a stagflationary environment, they could be hit with a double whammy as housing affordability slips further out of their reach.
