Americans have been exuberant about home-buying during the Covid-19 recession. As a result, sales of previously owned houses rose by 0.6% month over month to 6.69 million units last January, while the median existing-home price increased 14.1% year over year to $303,900 in January. Home inventory dropped by 26% to 1.04 million homes, the lowest on record.
The enthusiasm for home-buying during a recession may sound irrational, as home sales and home prices usually fall in recessions. However, the Covid-19 recession wasn't the usual recession due to unprecedented monetary and fiscal stimulus launched early on in the pandemic. That helped American households maintain purchasing power and urgency to move away from cities to suburbs, where housing markets have been hot.
Simply put, the American exuberance for home-buying during the Covid-19 recession wasn't irrational after all. But the home-buying exuberance has continued in recent months, even as the Covid-19 pandemic eased, as investors joined urban dwellers' bidding war for homes. As a result, year-to-date existing home sales are up 20%, driving home prices to record highs.
What's drawing investors into the home market? Rising inflation. Homes are considered good hedges against persistent inflation. That's why they have been popular assets to hold in emerging market economies where inflation runs high, and investment choices are limited. Homes have also been good hedges against inflation in developed countries like the U.S. in periods when inflation persisted for several years, like the 1970s. That's when U.S. median home prices almost tripled.
Is this renewed enthusiasm for home-buying rational or irrational? In my view, it largely depends on whether the recent surge of inflation is "transitory" or "persistent." As the term suggests, transitory inflation is temporary. It appears in economies in transition from sharp contractions to sharp expansions due to "bottlenecks." These are temporary disruptions and breakdowns of the supply chain of the economy.
Bottlenecks cause mismatches between the demand side of the economy and the supply side, which create commodity shortages and price spikes, pushing usual inflation gauges like the Consumer Price Index and the Producer Price index higher. Transitory inflation disappears once bottlenecks ease and the supply side of the economy catches up with the demand side.
Unlike transitory inflation, persistent inflation lasts for a long time due to the build-up of inflationary expectations among market participants. But, unfortunately, that sets the economy into a cost-push demand-push price spiral that can spin inflation out of control, as was the case back in the 1970s and the early 1980s.
What kind of inflation is the U.S. economy experiencing this time around? According to official statements made by the Federal Open Market Operations Committee (FOMC), it's likely transitory. Rising prices reflect delayed reactions of the economy's supply-side to a quick pick-up of the demand side, as the Covid-19 pandemic eases. That's how the Fed justifies its accommodative policy despite the strengthening economy.
Oxford Economics agrees with the FOMC. In April, the economic research company noted, "inflation is picking up across advanced economies (A.E.s), and emerging markets (E.M.s), but the data suggests this will again prove temporary. We see no signs of lasting pressures that might turn a temporary spike into a lasting overshoot."
The data the report is referring to is the "slack" in the labor market. The U.S. unemployment rate is standing at 5.8%, well above its natural rate of 4%, a threshold that could trigger cost-push inflation. Meanwhile, capacity utilization is standing at 74.9%, well below the full capacity level of 85%, which could fuel cost-push inflation.
Still, some bottlenecks may be far worse than initially thought, like in the labor market, where jobs remain unfilled even as unemployment rates remain elevated. That could force some employers to hike wages, which eventually will translate into higher prices for inefficiently-run companies (and there are an increasing number of these in the U.S. due to accomodative monetary policy allowing the formation of zombie companies).
Meanwhile, inflation has begun to build into consumer expectations, as evidenced by recent surveys, including one by the University of Michigan a couple of weeks ago. They show that inflation is a significant concern for consumers, and consumers know inflation better than anyone else when they see it at the supermarket register.
In short, there's a fine line between transitory and persistent inflation. It can be easily crossed if market bottlenecks persist, preventing the economy's supply-side from catching up with the demand side. And that would determine whether America's renewed exuberance for home-buying is rational or irrational.
