2 big changes that stagflation could bring about in the housing market

Stagflation is the worst of all economic worlds, one in which inflation is high, while gross domestic product growth is slow. That state of affairs prevailed at times during the 1970s, when big shocks to the economy triggered inflation and the Federal Reserve tried to bring it back under control without throttling growth. While the parallels between 2022 and the 1970s aren’t that great, they do offer some interesting takeaways.

image of a house under construction

Image source: Getty Images.

The Fed raises interest rates to curb inflation

At its March meeting, the Federal Open Market Committee (FOMC) agreed, as expected, to raise the federal funds rate by 25 basis points (or a quarter of 1%). Now it is in the range of 0.25% to 0.5%. The FOMC will meet six more times in 2022, saying after the March meeting that it expects to raise that benchmark interest rate again after each one. As such, he forecasts the fed funds rate to end the year between 1.75% and 2.25%. Historically speaking, that’s a pretty aggressive pattern of rate increases. And reflecting that, the Fed cut its estimate for gross domestic product growth for 2022 from 4.1% to 2.8%, and raised its estimate for the annual inflation rate to 4.1%.

Again, historically, 2.8% is a pretty strong growth rate for the US economy, and the Fed’s unemployment forecast stood at 3.5%, which is very strong. This means that the Federal Reserve is not predicting anything like stagflation. But what if the Fed’s anti-inflation measures prove too aggressive and stifle growth without containing inflation?

Rising construction costs make new homes more expensive

If that were to happen, commodity prices for things like energy, food and Construction materials would continue to rise significantly in price, driving up the cost of new construction. It is important to understand that all inflation indices are constructed using different methodologies. The Federal Reserve prefers to use the personal consumption index, which is different from the consumer price index more commonly referred to in the business press. These indices basically weigh a basket of goods and then use all sorts of adjustments to generate a modeled number to describe inflation. This means that increases in individual assets may or may not be increasing at the rate of the rate of inflation. According to the National Association of Home Builders, prices for building materials have increased 20% in the last 12 months and 31% since January 2020.

Higher construction costs would exacerbate affordability problems that already exist in the housing market. Nationwide home prices have been rising at a blistering pace year over year for the past year due to the record number of homes for sale. More inflation would only make this worse. Additionally, first-time homebuyers compete with large rental companies that specialize in single-family homes like American Homes 4 Rental (AM H 1.48% )who are also buyers of single-family homes.

Institutional money is crowding out first-time homebuyers

If stagflation sets in, 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 the few homes for sale. Institutions get mid-single-digit percentage returns on rents, along with a mid-teen percentage appreciation in house prices. That dwarfs the returns available from other asset classes, like corporate bonds, Treasuries or even stocks these days.

The second effect is that people are more likely to have a hard time upsizing or downsizing, especially if they have a fixed-rate mortgage with a lower interest rate than they could get again. More seniors are choosing to age in place rather than move elsewhere upon retirement. Families looking to move from starter homes to larger homes may find rising housing costs more daunting, so instead of buying a larger home, they may choose to upgrade their current one. That would be good news for home improvement retailers like house deposit (New York Stock Exchange: HD).

A trend of rising prices for new and existing homes generally leads to rising rents as well, which would be good news for apartments. real estate investment companies I like Residential Equity (New York Stock Exchange: EQR), which have locked in low interest rates on their debt for the past two years. As a result, your profit margins should increase.

In general, the most obvious impacts of stagflation would be felt by first-time homebuyers, who are rapidly being priced out of the market and will feel disproportionately the pressure of rising interest rates. If wage increases keep pace with inflation, then these people shouldn’t be worse off than they are now. But in an environment of stagflation, they could be dealt a double whammy as housing affordability slips further and further out of their grasp.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We are motley! Questioning an investment thesis, even one of your own, helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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