Volume 9 Issue 2

Warning: Inflation Ahead By Dr. Peter Linneman, PhD

Chief Economist, NAI Global
Principal, Linneman Associates

During this recession, we have experienced massive asset price

deflation. At the same time, we have also had consumer price deflation
coming primarily through oil. However, falling oil prices provide increased
purchasing power and leave more money in our pockets, and therefore
act as net wealth increases for the U.S. The asset price deflation
obviously has the opposite effect on wealth. Core inflation, net of food
and energy, is still running in the range of 2-2.5%. Thus far, we have
had assets declining dramatically in value, but overall, consumer goods
pricing has been fairly stable primarily because the velocity of money
has massively declined. Going forward, it may be a very different
ballgame because as each dollar is spent more frequently (indicating
greater demand), prices will rise.
Table of Contents
From the beginning of September 2008 through the end of February Unequal Blessings vs. Equal Miseries
2009, the Fed increased the money supply (M1) by 11.8%, while the Worst Ever Yet?
velocity of money fell by 7.8%. As a result, overall inflation has stayed When, if Ever Again, Will the Good Times Roll?
steady even though significant asset price deflation has occurred. How Quickly We Forget
Absent this massive monetary expansion, we would have witnessed an Let’s Understand Why We Save
enormous deflation due to the decline of velocity. Warning: Inflation Ahead
The Tax Man
Fear – driven by enormous uncertainty and panic created by the The Height of Regulatory Hubris
abandonment of clear economic rules – caused the massive and New Salvation?
precipitous decline in velocity. Given capricious and irrational Lessons (Re)learned
government policy decisions, cash became the only safe haven. Where Are Real Estate Prices?
After Mr. Paulson declared that the world was coming to an end in early Construction Costs
September 2008, sophisticates jammed their money into Treasuries to The Linneman Letter Look-Back: Construction Costs
the point where they yielded negative real returns. Americans pulled Comparing Social Conditions from the Great Depression with Today
their money out of hedge funds, stocks, bonds and real estate, A House Divided: Global Recession Threatens European “Union”
The Linneman Letter Look-Back: Is The Euro Doomed?
and put it in banks, money markets, and shoe boxes as they became
Euro Failure Coming?
frightened about the soundness of the system. This occurred even
Market Close-Up: Atlanta Office
as the Fed and Treasury officials could not figure out why these runs
Market Close-Up: Minneapolis Industrial
took place. Guys, you told them to panic, and they did!
Market Close-Up: Philadelphia Multifamily
It is breathtaking how the Obama administration has replaced the Market Close-Up: Dallas Hotel
Bush administration’s stunning arrogance of ignorance with an equally Office Market Outlook
stunning arrogance of intelligence. Hardly a day goes by without a new Industrial Market Outlook
“solution.” Problems at Citi: give them more money. Sales are lagging at Multifamily Market Outlook
Retail Market Outlook
GM: replace the CEO. Hedge funds acting as fiduciaries for retiree
Hotel Market Outlook
money refuse to abrogate their senior claims on Chrysler: publicly
Senior Housing Market Outlook
renounce them as “speculators” (as opposed to debt holders acting in
3-year Vacancy/Occupancy Forecasts
good faith to protect their legal rights). Tell them you will make sure they
will fare even worse in bankruptcy and pressure the bankruptcy judge.
Bonuses paid according to a contract and blessed by the governing

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 Volume 9 Issue 2

body (including government representatives): label them thieves and

Consumer Price Index
target tax them. Planning to attend a conference: chastise attendees Year-Over-Year Percent
7
for being profligate (even as the G20 representatives spend wildly on 6
their own photo-op boondoggle). You desire that UAW members gain 5
4
from bankruptcy and threaten secured senior debt holders. We had

Percent
3

high hopes that the Obama administration would restore the rules 2
1
and processes destroyed on both the economic and social front. 0
-1
Sadly, they have subjected us to perhaps even greater arbitrary over- 1984 1988 1992 1996 2000 2004 2008
reach. It boggles the mind that they are wantonly ignoring contractual Core CPI CPI for Services CPI - All Items

rights even as they beg investors to accept subsidized government

funds to restart capital markets. Do they not see the contradiction?

It is laughable that the government’s new TALF and PPIM programs M1 Year over Year Percent Change
18
rely on rating determinations by the same rating agencies who have
15
been clearly discredited. It seems the old adage “close enough for 12
9
government work” applies. Similarly, why do they continually say that

Percent
6
PPIM will buy “toxic” assets, when they are strictly focused on AAA- 3
0
rated instruments? After all, Simon Properties bonds are rated A-,
-3
so if the ratings mean anything, the debt to be purchased is far less -6
1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009
“toxic” than Simon debt. If they really want to buy toxic assets,
why not focus on the sub-AAA assets?

Some $30 trillion was knocked off the peak market value of global
M2 Year over Year Percent Change
equities, including $7 trillion in the U.S. If you think this was because
14
of subprime loans, you have to explain how $1.3 trillion in total face
12
value can destroy so much value in so many disparate places. 10
Percent

It was the flight to cash in the face of arbitrary government decision 8

6
making that crushed asset values. It is what has driven investors out
4
of markets causing excess volatility and abnormal levels of illiquidity. 2
This is seen in the fact that while over the last 50 years, only 1% of 0
1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009
trading days saw increases/decreases of more than 3%; since the
governmental madness began in September, 38% of trading days
exceed 3% changes. Furthermore, half of the 50 most volatile trading
days (in percentage terms) since 1950 have occurred since Money Velocity*

September 2008. We beg you, please stop helping us! 1.8

1.7

The result is that cash held at banks (the monetary base) doubled 1.6

during the last two quarters of 2008 from $832 billion in June to 1.5

$1.6 trillion in December. It increased nearly another $120 billion in 1.4

1.3
the first 5 months of 2009. Similarly, checkable deposits and
1.2
currency, small time savings deposits, and money market fund 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009
shares increased by $1.3 trillion or 13% on a combined basis over *Personal Income/M2

the second half of 2008 and into the first quarter of 2009, rising
from 7.0% of total financial assets to 8.3%.

Meanwhile, bank excess reserves have soared from $2 billion in

August 2008, to $844 billion in May 2009. As a percent of total
reserves, they rose from 4.5% in August to 93.5% in May, while as a
percent of required reserves, excess reserves rose to over 1,400%.
In September 2008 alone, excess reserves rose by $58 billion. They
rose an additional $208 billion in October, a further $290 billion in
November, and $208 billion in December. All this occurred even as
required bank reserves rose by a mere $11 billion.

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To grasp the magnitude of this, if we exclude the 9/11-induced panic

Reserve Assets Held at Federal Reserve
in September 2001 (which drove excess reserves to 33% of total 95
reserves), the 50-year average to August 2008 was 2.6%. Similarly, as 85
75
a percent of required reserves, excess reserves have been between

$ Billions
65
1-5% over the last 50 years. Massive amounts of cash are sitting with 55
the Fed and on company balance sheets. History tells us that banks 45
35
do not operate with $700-800 billion excess reserves for very long.
25
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
These unprecedented bank excess reserves, combined with the Foreign Reserve Assets US Reserve Assets
enormous increase in cash holdings, mean that as banks begin to
lend their excess reserves and the velocity of money begins to rise,
there will be a stunning surge of liquidity chasing goods, services,
and assets. In theory, the Fed will perfectly foresee these changes in Monetary Base: Cash Holdings at Banks
1,800
velocity and will perfectly take money out of the system by selling
1,600
(instead of buying) bonds and by raising interest rates. This would
1,400
sop up excess liquidity, thereby avoiding asset and consumer price

$ Billions
1,200
inflation. But if you believe that the Fed is prescient, you have not 1,000

been paying attention. 800

600
At best, Fed efforts will lag by 6-24 months, leaving the potential for Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Mar-09 May-09
a rapid, double-digit spurt of inflation. Realistically, we expect to get
a spurt of inflation as high as 10%, even as the Fed tries to shrink
the monetary base.
Historical Required Reserves by Banks
Faced with red hot government printing presses, “gold-bugs” (such 70

as Steve Forbes) cry for a return to the gold standard, which was 60
50
abandoned by the U.S. in 1971. Their claim is that since nothing
$ Billions

40
backs paper money, there will be excess money creation and 30

inflationary debasement of the fiat. However, the gold standard has 20

10
experienced numerous instances of high inflation following new gold
0
discoveries. For example, hyperinflation, not booming prosperity, 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009

occurred in Spain following the Spanish gold discoveries in the New

World. And deflation and crashes occurred when the production
of gold lagged economic growth potential, as the linkage between
extraction and potential growth is extremely tentative at best Recent Bank Excess Reserves
(and indefensible at worst). 900 824 844
800 767 798
725
700 644
Gold standard monetary systems also experienced high inflation 559
$ Billions

600
500
whenever the government changed the paper-to-gold exchange 400
300 268
ratio, or simply decided to go “off gold” and print paper money to
200
cover rapidly rising government spending. The crux of the matter 100 3 2 2 2 2 2
60
0
is not gold-backed paper, as governments have frequently Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Mar-09 May-09
repudiated this policy overnight. The real issue is disciplined
government spending and balanced budgets. Money printing
rampages are always completely about a deep lack of spending
restraint by government (such as today), not about whether
gold-backed or fiat paper is being debased. The “gold-bugs” fail
to grasp this fundamental truth.

The U.S. has historically been among the most disciplined nations
in terms of government spending (though we will see whether that
will continue). This may be sad, but it is nonetheless true. In recent
history, the U.S. government spends 18-21% of GDP, versus

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 Volume 9 Issue 2

40-60% for most of the world. In the extreme, if a country’s

Federal Spending as Percent of GDP
government only spends 1% of GDP, it can pay for this spending by 70

printing paper equal to at most 1% of GDP. But as government 60

spending rises, so too does the temptation to print money rather 50

Percent
40
than tax. Runaway government spending (relative to the willingness
30
to pay taxes) is a necessary precedent to rapid currency debase-
20
ment. Hence, there is the fear of inflation in the current environment.
10
Federal spending will rise by 8-12% of GDP in a year, as the tempta-
0
tion to “run the presses” to pay for this spending will be very difficult U.S. U.K. Germany France Japan

to resist. This is equally the case with or without a gold standard.

How will commercial real estate fare in the face of an inflationary

spurt? If higher inflation is limited to a 100-200 basis point increase
Government Receipts, Outlays, and Deficit
which lasts for a year or so, the effects will be of secondary order
25
on both property cash flows and values. However, it will crush 20
highly levered floating rate borrowers who are barely above water at 15

Percent
10
near-zero short-term rates. If the inflationary surge is larger, it will 5
0
favor those with short-term leases (like hotels and multifamily rental) -5
-10
and properties with large near-term rental rollovers. It will also favor
1954 1960 1966 1972 1978 1984 1990 1996 2002 2008
those with long-term fixed-rate debt, as they will be able to repay Receipts Outlays Deficit
their debt obligations with unexpectedly debased currency. For
example, 2% of unexpected inflation reduces your real debt liability
by 15% over seven years. The hardest hit will be owners who
mismatched long-term leased properties with loads of short-term
Government Receipts, Outlays, and Deficit
debt, as their incomes will not rise in spite of rising inflation, even 4
as their debt service soars. 2

0
Real estate would be a favored asset if that spurt occurred,
Percent

-2
especially if you have shorter leases, such as with multifamily, and
-4
if you have long-term fixed-rate debt. If you get a spike of inflation,
-6
it is always good to have the ability to increase revenues, while
-8
keeping interest costs fixed. So right now, we are bullish on
1954 1960 1966 1972 1978 1984 1990 1996 2002 2008
multifamily in strong markets financed with long-term debt. It is
the best positioned asset to cope with a spurt of inflation, in that you
can renew your leases to reflect inflation, but your cost of capital
will not immediately be re-priced.

When the inflationary spurt will happen is difficult to predict,

as economic analysis is poor at predicting timing. Further, the roles
of psychological forces and government policy far outweigh
economics in this instance.

The magnitude of the current liquidity situation is unprecedented,

rendering historic comparisons of little use. Our intuition is that
the inflation of assets and consumer prices will be well underway by
mid-2010. To the extent that the inflation spurt hits asset prices,
it will reverse much of the $9.5 trillion (16.2%) decline in real
household wealth which occurred in the past year through the first
quarter of 2009.