May 12, 2022 • 6 min read • Market News

A word seldom heard in today’s economic climate may have been a strong consideration in recent decisions to hike federal fund rates: deflation. Deflation indicates a time of decreased consumer confidence, business spending, and personal spending, in anticipation of continued falling goods prices. Considered to be the Federal Reserve’s worst enemy, deflation is particularly difficult to control or influence, if not impossible at times. Unlike in times of inflation, where the Federal Reserve can influence consumers to lower spending and investment activity by tightening monetary policies—as witnessed through increased rates and selling back mortgage-backed securities to decrease the money supply, the Fed’s ammunition does not prove to be as effective in times of deflationary periods, especially when rates are already at zero. A consumer with the anticipation of continued decreases in the prices of goods will revert to holding cash in deflationary periods. 

The Federal Reserve recently retired using the word “transitory” when discussing inflation. Though the Fed initially stated that inflation was the sole result of supply chain bottlenecks due to COVID-19, the Fed has now repositioned its stance, attributing a myriad of factors as the catalysts. We, too, were in the camp of inflation being transitory, and still believe it is likely to subside by years end, under the conditions that COVID-19 slows its growth rate in China (supply chain concerns), global tensions (Russia/Ukraine) do not escalate and sanctions surrounding oil distribution ease. Globalization over the past few decades has had a disinflationary effect, and may be on a reverse-course as nationalism takes center stage. As a firm, Yieldwink believes that deglobalization can be the greatest inflation threat, though it is not likely to occur in droves soon. A route back to the USA for manufacturers would mean higher production costs due to higher paid wages.

While the effects of inflation vary from consumer to consumer based on their individual needs and expenditures, common categories such as housing, rent and gasoline prices tend to affect the broader population. You can find the Consumer Price Index (CPI) figures by expenditure category here. CPI is the most widely used measure of inflation. 

Inflation contributors:

Wage Inflation: COVID-19 and work-from-home (WFH) policies came with unexpected behavioral changes in workers. The freedom brought forth by WFH policies had many workers dread a return to the office while appreciating the time saved from work travel. The growing gig economy also inspired the once-hidden entrepreneurial spirits of many. The combined factors led to the Great Resignation, forcing employers to increase wages to retain and hire top talent in a constricting supply of workers. In our view, wage inflation is likely to continue as recovery begins in the trailing public, leisure and hospitality sectors – flooding an already supply-heavy job market. 

Personal Savings & Spending: COVID-19 WFH policies resulted in increased consumer savings. For some, even with inflation running rampant at 8%, WFH savings outpaced individual inflation effects, with employees saving ~10% from transportation and eating-out expenses*. For many laid-off employees, unemployment and additional COVID-19 benefits provided higher wages than those received previously from employers. WFH and unemployment benefits led to higher consumer savings rates, which, in result, led to an increase in consumer spending. Price inflation resulted from an increase in consumer demand tagged with a decrease in goods supplies. 

Energy Prices: Oil prices were the greatest contributor to CPI numbers last year, with overall energy up 32% year-over-year. Energy costs also indirectly affect core CPI (which does not include energy or food prices), as the higher cost of oil affects the transportation costs of goods. A shortage in the workforce, including truck drivers, further increases the cost of delivery of these goods. Gasoline prices have increased 48% year-over-year from March 2021 to March 2022. The role of gasoline in transportation costs affect nearly every household item cost – a major component of CPI’s composition. You can see the breakdown of CPI by its weightings here. 

Airline fares, energy costs and food were the largest contributors to last month's CPI increase.  While inflation is a major catalyst for the Federal Reserve raising rates, we do not believe it is the only reason.

Raising rates- the Fed’s only tool:

The Fed Fund rates (the interest rate at which depository institutions lend reserve balances to other depository institutions overnight on an uncollateralized basis) had remained near zero from the latter part of 2009 until this year. The Federal Open Markets Committee (FOMC) uses the Fed Funds rate as a tool to influence the cost of borrowing money– affecting spending and investment trends. The federal funds rate influences how much consumers are paid to save their money (CD bank rates), and how much consumers are to pay on borrowed money (loans from banks). In times of distress (recession), the federal funds rate is lowered to influence more borrowing and investments outside of Treasuries. While in times of great economic activity, the federal funds rate is sometimes increased to curb over-leverage and inflation, as witnessed in today’s economy. 

While an immediate recession seems unlikely (in our opinion), the FOMC has started its increase in the federal fund rates while alluding to an expectation of increased rates over the year, citing inflation as a growing threat. While we do believe it is the committee's intention to curb inflation with rising rates, we do not believe it is the sole reason for its adjustment. 

With rates at zero, the FOMC loses this powerful option in slowing economic cycles: the option to lower rates to stimulate economic activity. As stated previously, a deflationary environment is much harder to combat than an inflationary environment. A consumer is more easily influenced to borrow less money because of higher borrowing costs than the consumer is to spend money in an environment of rapidly falling prices or poor economic activity. The FOMC must be prepared for unforeseen market environments, and therefore must keep ‘arrows’ in the quiver. We feel the option to increase or decrease rates is a priority for the Fed. 

It is our belief that while rates are likely to rise for the next year, it is unlikely that rates continue to rise for consecutive years. Upon the FOMC’s success in curbing inflation and halting an overheating market, we believe it to be likely that the FOMC reverse its trend and again lower rates to influence further lending and investments amid early signs of a peaking economy. 

So how do our assumptions impact our real estate investment underwriting? For one, we distinguish between borrowing costs on the longer fixed term versus short term. Factors that we consider include yield maintenance penalties and alternative funding sources, such as bridge loans  (if a value-add project), or CMBS. With our assumption of the likelihood of declining rates within the next 2-3 years, a step-down prepayment penalty may be favored over yield maintenance, as the latter may come with heftier penalties when refinancing. For traditional investors looking for yield in bonds or bond funds, we believe shorter duration and floating rate funds may be better options to combat the immediate rise in rates. Floating rate funds may also provide a higher Sharpe ratio than High Yield in a rising rate environment. For investors looking for inflation protection, inflation-protection funds with CPI swaps may serve as a better alternative to TIPS, which tend to have longer effective durations.

Yieldwink holds the opinion that inflation will likely level off by years-end, under the conditions aforementioned in this article. It is our belief that the recent rate hikes were not only used as a tool to curb inflation, but also as a necessity to bolster the Federal Reserve’s defense in the wake of recessionary periods. 

Footnote: * assumption, NYC workers with $65,000 annual salary.

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