WP3: Rising Inflation Surges as the Federal Reserve and the United States’ Commercial Real Estate Sector Brace for Impact

Part 1

The CPI Index and Inflation

The Consumer Price Index (CPI), less food and energy, is considered the core index for inflation in the United States. The Federal Reserve uses this index due to the increased volatility of the food and energy sectors. The index is calculated from a subset of goods and services that infrequently change prices. This infrequency, also known as sticky prices, incorporates expectations about future inflation more accurately than a basket with frequent price change. 

The Consumer Price Index is at the forefront of economic discussion due to a recent spike in its rates. According to Federal Reserve Economic Data (FRED) from the Federal Reserve Bank of St. Louis, United States inflation less food and energy was at a four-decade high this September at 6.39% (FRED). 

Source: FRED Economic Data St. Louis Federal Reserve    

The report on increased inflation suggests that the Federal Reserve (Fed) will increase interest rates as part of their monetary policy strategy to keep their long-run goal of 2% inflation. The increase in inflation also poses the risk of postponing the anticipated slowdown of increases to the interest rate. The Federal Open Market Committee (FOMC) reaffirmed their stance on the Fed’s monetary policy strategy effective January 25, 2022. 

Traditionally the Fed’s primary means of conducting monetary policy involves changing money supply through open market operations or the buying and selling of government securities (shifting reserve supply). This manipulates the target range for the federal funds rate (FFR) which alters the amount of reserves available in the banking system. With the Fed’s decision to leave “ample” reserves in the banking system due to the financial crisis, this leaves the reserve supply curve situated in the flat portion of the demand curve. A large quantity of reserves makes minor adjustments to the supply of reserves ineffective. As a result, the Fed has shifted its primary method for adjusting the FFR. 

Source: Federal Reserve of St. Louis

The new framework, namely the Ample Reserves Regime, uses two “administered” rates rather than rates determined in the market to set the FFR target range (Ihreg). These two rates are interest on reserves (IOR) and the overnight reserves repurchase agreement (ON RRP) rate. IOR allows banks to deposit cash into their reserve account with the Fed and earn interest on their reserves. Since IOR provides a risk-free option for banks, IOR acts as the reservation rate– the minimum interest rate a lender will offer when making a loan (Ihreg). When banks decide to lend out their reserves to other banks, in order to make it “worthwhile,” they will charge a higher interest rate, which in turn dictates the rates banks charge their customers (Economist). 

The ON RRP rate acts in supplement to the IOR, as some financial institutions in the federal funds market do not have access to interest on reserves. This means the FFR could drop below the set IOR rate. The ON RRP facility works in the following manner: The Fed sells U.S. government securities to financial institutions with the simultaneous promise to buy back the security the next day. When an institution utilizes the facility, they deposit reserves in the Fed overnight, receiving government security as collateral. The following day, the Fed buys back the security, and the institution earns the ON RRP rate from the cash it deposited at the Fed (Ihreg). The Fed sets the ON RRP rate lower than the FFR to compliment the IOR. 

Source: Federal Reserve of St. Louis

In addition to the FFR, the Fed sets the discount rate for financial institutions. The discount rate is offered at the Fed’s “discount window” and is the interest rate the Fed charges financial institutions to borrow funds directly from them. The Fed tends to set this rate higher than the target FFR to promote financial institutions (banks) to borrow from other banks.

How Do Raising Interest Rates Impact Inflation?

The Fed’s principal goal from engaging in monetary policy is to promote “maximum employment, stable prices, and moderate long-term interest rates” in the economy (United States). During periods of high inflation, unemployment lowers; however, when there is inflation, this leads to price instability. Once the Fed introduces contractionary monetary policy, the economy both directly and indirectly experiences the effect of increased interest rates. 

For example, in the housing market, when mortgage rates are floating, higher interest rates have an immediate impact on consumer spending, resulting in less spare cash. Hence, high interest rates lower inflation. When mortgage rates are fixed, the impact of rising interest rates still exists but is not direct. Current mortgage rates become relatively more expensive than prior rates, causing demand for homes to decrease. As a result, home prices fall, leaving homeowners with the illusion that they are poorer. Lower home prices correlate to less spending, lowering inflation (Economist). 

Interest rates also impact the economy’s inflation via its impact on corporations. When interest rates increase, borrowing costs increase, lowering the amount of investments made by firms. High costs of borrowing and less incentive to invest decrease the amount of money loaned, decreasing the amount of money in circulation. Thus inflation lowers. Tighter lending standards also affect many corporations’ net income and revenue which in turn reduces economic growth. Moreover, less spending can reduce the number of employees hired and slow productivity for the firms. 

More generally, the Fed raises interest rates to slow the economy enough for a decrease in consumer and corporate spending, slow wage growth, and lower prices.

What is Causing Current Inflation?

Many economists trace product shortages and global supply-chain issues created by the Covid pandemic as the primary catalysts for increasing inflation. Economists also cite strong consumer demand and government monetary intervention which includes decreasing interest rates as the cause for high inflation. 

Inflation and Subsequently Interest Rates’ Impact on the Economy and the Commercial Real Estate Sector.

In today’s context, inflation not only impacts the U.S. economy but also the global economy. Countries around the world are engaging in various mechanisms to tame inflation as well as to remain competitive with other nations’ economic policies (Horner). Similar to the United States, The Bank of England (BOE) and Swiss National Bank have both raised their key interest rates. Japan, on the other hand, intervened in the currency markets by selling dollars and buying yen in order to decrease money supply. Turkey has remained an outlier in this race, remaining firm on their view to keep interest rates low while, ironically, expecting low inflation.

So what does the increase in inflation mean for consumers and businesses in the economy? The current rise in inflation as a result of the Covid pandemic has left a sizable impact on the livelihood of consumers. Food prices, housing, and medical care experienced significant price increases. This September, grocery and dining prices were 13% and 8.5% higher than prices 12 months prior, respectively. Gasoline prices in September were 18.2% higher than a year ago (Tepper). Residents of Los Angeles have witnessed gasoline prices surpass $7 per gallon. Businesses struggle to incur additional labor, materials, and energy costs. These increased costs are in-part passed onto consumers through increased costs for goods and services. Moreover, despite a strong job market increasing workers’ pay, the increase in pay is not enough to offset rising the price level.

What about the real estate sector? Tightened financial conditions, as a result of rising inflation, threaten global growth in the commercial real estate (CRE) sector due to the increased real cost of borrowing. This inhibits investors from financing new deals or refinancing existing loans, lowering overall investment. In the U.S. rising interest rates continue to sink deals. Consequently, property sales are down 16% from one month ago in contrast to thirteen consecutive months of increasing sales (Parker). 

Compared to historic levels, interest rates are still at an attractive level. Real estate asset managers suggest businesses should take advantage of the current rates before a more significant increase. Businesses should also consider other economic factors such as supply, demand, and demographic shifts; the local market; and current financing structure of loans when making investment decisions (“What Interest”).

According to the International Monetary Fund (IMF), global property prices in the industrial and residential sectors are experiencing a sharp decline, on average, as seen in the chart below.

Source: International Monetary Fund

A recent analysis by the IMF determined financial conditions are a significant driver of CRE prices citing the overall trajectory of the pandemic, changes in demand for differing property types, and broader macroeconomic recovery as important factors for the future of the real estate sector. These factors supplement city-level data showing that the recovery period in the CRE sector is closely related to the regional spread of Covid-19 and the relative strength of containment measures (Deghi).

As a result of the declining market, financial institutions such as banks are re-evaluating their underwriting assumptions to determine adequate capital reserves and mitigate risk. 

What’s Next?

With much uncertainty around the future state of the economy, it is difficult to predict what lies ahead for the U.S. economy. That said, inflation will likely continue due to a consistent increase in core inflation. Furthermore, the sharp increase in house prices over the past two years suggests that core inflation may remain inflated in the near future despite a slight decrease in residential home prices. The Fed’s increase in interest rates will unlikely induce a recession itself, however, the hike in rates will have a short-term impact across economic sectors. 

Consumer spending on goods will likely continue to decrease in the near future. In the housing sector, increased cost of borrowing will reduce construction and decrease demand for homes in the short term. Housing is not anticipated to be a driving factor for economic growth in the medium and long term due to low population growth. 

Business growth forecasts suggest that tightened financial conditions will keep the financial sector at low growth for the short term. Appreciation of the U.S. dollar also suggests exports will fall. Government spending will decrease marginally as a result of countermeasures for inflation. That said, in the long term, the federal government’s infrastructure bill will offset this decrease (Bachman). 

Part 2

Upon reflection of Writing Project 3, I chose to write an academic journal article as a direct result of the research I completed during Writing Project 2 (WP2). Specifically, I found myself inspired by the writings published in the Wall Street Journal, the Economist, and by the International Monetary Fund (IMF). These writings were concise, factual, and addressed current issues in economics that I was interested in learning more about. Moreover, I found writing an academic journal article aligned well with my intent to cover the current rise in inflation. Another motivation I found to write an academic journal article included writing for the benefit of my own understanding of the topic and interest in writing for a platform that targets an audience similar to myself such as the USC Economics Review. I relied on the assumption of these audiences when drafting my article. 

An academic journal article’s intent is to cover a particular academic discipline formatted with a serious and scholarly appearance. It targets a readership of professors, researchers, students, and peers in the respective field. After narrowing down my intended genre of writing, I took it upon myself to further research the stylistic and formatting conventions of an academic journal article. One source that caught my attention was a blog post entitled “5 tips on writing from ‘The Economist Style Guide’.” In this article, Author Sharp outlines the five largest lessons he took away from the ‘The Economist Style Guide.’ The author lists his top five takeaways as: 1) do your best to be lucid, 2) do not be stuffy, 3) don’t be too didactic, 4) catch the attention of the reader, and 5) read through your writing several times (Sharp). These tips became the foundation for the conventions I chose to utilize for Writing Project 3. 

The main convention I abided by while writing Writing Project 3 (WP3) falls in line with our in-class discussion on sentence structure; that is, to be concise. In the words of Author Sharp, “Good writing is simple writing. Less is more” (Sharp). Due to the nature of economic material, I found concise sentences were more than enough to effectively articulate my commentary and eliminate ambiguity in the information stated. I also leaned into saving perfection for the editing process, per feedback from the past two writing projects’ conferences. 

Unlike WP2, my topic of focus in WP3 shifted from the impact of the Covid-19 pandemic to a greater focus on post pandemic economic activity. This shift in focus altered the resources I used to craft my article. In turn, I relied heavily on publications from the various Federal Reserve branches and analyzing market trend data based on economic principles. In comparison to the sources I used in WP2, these contained much more crude syntax. This is likely due to a change in the target audience of the writing. Whereas newspaper and magazine articles attract a general white-collar audience, I feel the publications written by the Federal Reserve are geared towards individuals with a quantitative or financial background. Hence, these articles tend to read more dry. I believe the slight difference between these genres made my WP3 a blend of the two genres. Since the stylistic and formatting conventions of my WP3 sits somewhere between a newspaper and government publication, I think blending the two genres made the most sense. Ultimately, I am pleased with the genre I chose for this project and believe that it is the most meaningful way I can contribute to the discourse surrounding the topic.

Works Cited

Bachman, Daniel. “United States Economic Forecast.” Deloitte, Deloitte, 15 September 2022, https://www2.deloitte.com/us/en/insights/economy/us-economic-forecast/united-states-outlook-analysis.html. 

Deghi, Andrea, et al. “Commercial Real Estate Prices During COVID-19: What is Driving the Divergence?” Global Financial Stability Notes, August 2022, pp. 1-15. International Monetary Fund. https://www.imf.org/en/Publications/global-financial-stability-notes/Issues/2022/08/01/Commercial-Real-Estate-Prices-During-COVID-19-What-is-Driving-the-Divergence-521593. 

Deghi, Andrea, et al. “Commercial Real Estate Sector Faces Risks As Financial Conditions Tighten.” Chart of the Week, 22 Sept. 2022. International Monetary Fund. https://www.imf.org/en/Blogs/Articles/2022/09/21/commercial-real-estate-sector-faces-risks-as-financial-conditions-tighten.

​​Economist, The. How Does Raising Interest Rates Control Inflation? The Economist, 2022, https://video.alexanderstreet.com/watch/how-does-raising-interest-rates-control-inflation. 

FRED Economic Data. “Sticky Price Consumer Price Index less Food and Energy.” Economic Research Federal Reserve Bank of St. Louis, https://fred.stlouisfed.org/series/CORESTICKM159SFRBATL#.

Horner, Will, et al. “World’s Central Banks Race to Raise Rates After Fed Increase.” The Wall Street Journal, Sept. 22, 2022.

Parker, Will, et al. “Commercial Property Sales Slow as Rising Interest Rates Sink Deals.” The Wall Street Journal, June 7, 2022. https://www.wsj.com/articles/commercial-property-sales-slow-as-rising-interest-rates-sink-deals-11654594380. 

Sharp, Callum. “5 tips on writing from ‘The Economist Style Guide’.” Callum Sharp Writes, The Writing Cooperative, 14 March 2018, https://writingcooperative.com/5-tips-on-writing-from-the-economist-style-guide-28a7ff736ade. 

Tepper, Taylor. “Why Is Inflation So High?”. Forbes Advisor, 13 October 2022, https://www.forbes.com/advisor/investing/why-is-inflation-rising-right-now/. Accessed 31 Oct. 2022.

United States, Federal Reserve. “Monetary Policy: What Are Its Goals? How Does It Work?”. Monetary Policy Principles and Practice, https://www.federalreserve.gov/monetarypolicy/monetary-policy-what-are-its-goals-how-does-it-work.htm#:~:text=The%20Federal%20Reserve%20Act%20mandates,for%20monetary%20policy%20is%20commonly. 

United States, Federal Reserve of St. Louis, “How Does the Fed Influence Interest Rates Using Its New Tools?”. Open Vault Blog, by Ihrig, Jane, and Wolla, Scott, 5 August 2020, https://www.stlouisfed.org/open-vault/2020/august/how-does-fed-influence-interest-rates-using-new-tools.

“What interest rate hikes mean for multifamily property investors.” J.P. Morgan Chase, Sep. 30, 2022. https://www.jpmorgan.com/commercial-banking/insights/rising-interest-rates-effect-on-commercial-real-estate. 

Wiseman, Paul. “EXPLAINER: Why US inflation is so high, and when it may ease.” AP News, 13 July 2022, https://apnews.com/article/why-is-us-inflation-so-high-4b603a7fff0503360d5cc17a82f17ab1. Accessed 31 Oct. 2022.