WHAT WILL THE FED DO ABOUT INFLATION?

The Fed is walking a razor’s edge between rising inflation and a potential recession. So-called fedologists have been working overtime trying to predict policy changes that will have a significant impact going forward.

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Inflation has been a problem for some time, and there are reasons to think it could worsen. The war in Ukraine is exacerbating supply chain backlogs, Covid lockdowns in China, and the winding down of household savings from their Covid-era nest eggs.

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Prices are significantly higher for key economic inputs such as oil, grain, fertilizer, industrial minerals, and semiconductors. All this is happening when labor markets are already very tight.

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I have been watching Fed signals along with other financial professionals. Fed Chairman Jerome Powell is taking a gentle approach by tightening the money supply in small increments.

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Clearly, he would rather see inflation survive a bit longer than risk triggering a sharp recession. He’s also hoping that the market’s anticipation of tighter money will inspire a market correction, without him actually needing to hike interest rates dramatically.

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This is understandable, but I don’t know if it’s sustainable. The Fed prefers to use a soft touch, especially with an election coming this fall. Recessions hurt.

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However, inflation also has a big downside, and I wonder if Powell may need to shift into a new role, soon. Price stability is one of the Fed’s core mandates, along with full employment. And we’re already at full employment.

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Interest rates will need to continue rising. The only question is how much and how quickly. Rates are still relatively low by historical standards. When we factor in high inflation, real interest rates are even lower still.

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As borrowing costs rise, the growth in many asset prices will slow as well. This transition in the markets is just getting started, and I’ll be keeping a close eye on developments.

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Alliance offers a range of investment strategies that enable us to succeed in any interest-rate environment. We will continue to monitor the situation and adjust our investment strategies to reflect market conditions.

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Frequently Asked Questions (FAQs)

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What Is the Relationship Between Inflation and Interest Rates?

Inflation and interest rates move together because policymakers raise rates to slow inflation and reduce economic demand. This relationship directly affects interest rates and inflation expectations, which in turn influence asset pricing and underwriting assumptions. In commercial real estate, these shifts are reflected in valuation work performed through commercial real estate appraisals and cap rate adjustments. Understanding this relationship helps investors assess timing, pricing, and long-term risk across market cycles.

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How Do You Calculate the Real Interest Rate?

Real interest rates are calculated by subtracting the inflation rate from the nominal interest rate, revealing the true cost of capital. This calculation is essential when evaluating long-term returns, especially in assets where residual value meaning and exit assumptions matter. Investors often use this framework alongside methods that calculate residual value in development and value-add strategies. Comparing real interest rates also helps investors weigh real estate against alternatives such as bonds in changing interest-rate environments.

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What Is the Impact of High Interest Rates?

The impact of higher interest rates includes increased borrowing costs, tighter credit conditions, and pressure on property values. These effects place greater importance on cash flow durability, depreciation benefits, and conservative leverage. Investors often evaluate these factors by assessing commercial real estate depreciation and downside protection. Higher rates also amplify real estate investment risk analysis, making disciplined underwriting essential.

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How Does the Labor Market Affect Inflation?

A tight labor market drives labor market inflation as wage growth increases operating and construction costs. These rising costs feed directly into broader inflation, affecting feasibility and long-term projections. In real estate, labor trends are closely tied to demand patterns, as explained in the section on how demographic trends shape commercial real estate. Sectors supported by long-term demographics, such as healthcare properties, often show resilience during labor-driven inflation cycles.