Milton Friedman famously warned that "inflation is always and everywhere a monetary phenomenon." More than 50 years later, the U.S. Federal Reserve (Fed) is evidently putting Friedman's assertion to the test. The size of its balance sheet has nearly doubled since the start of the Covid-19 pandemic.
At DWS, we believe that the inflationary consequences will be relatively benign, tempered by slack labor markets and an orderly unwinding of monetary stimulus over time. In his famous lecture, even Mr. Friedman tempered his claim of higher prices for goods and services as an inevitable consequence of monetary growth in much of the rest of his remarks. Yet pricing pressures have begun to surface in places such as the commodity markets (e.g., oil and lumber), particularly relative to last year's depressed levels. There is arguably a risk that massive fiscal stimulus, monetized by the Fed, could overheat the economy, particularly if the supply-side cannot keep pace. In a recent example, an acute semiconductor shortage has already disrupted manufacturing, including automakers, which could put upward pressure on prices. Inflation break-evens appear to acknowledge this risk, rising steadily in recent weeks.
While sustained inflationary pressures are by no means guaranteed, today's extraordinary macroeconomic environment surely calls at least for some inflation protection. Investors have numerous options, such as inflation-protected securities and commodities. Historically, investors have also looked to real estate. As the chart shows, U.S. commercial property has exhibited a strong correlation to inflation, particularly during the 1970s and early 1980s. The correlation is not perfect: other factors, such as secular forces (such as demographics or, more recently, the rise of e-commerce) and interest rates, are also important. But rents typically respond positively to inflation as increasing corporate earnings among tenants support nominal rental demand. Meanwhile, higher construction costs restrict supply. Over time, real-estate prices converge to replacement costs, which are directly tied to inflation. If inflation fears continue to escalate, expect to see more investors looking at real estate as a potential hedge.
Sources: Refinitiv and DWS Investment GmbH as of 3/22/21
1 . The Counter-Revolution in Monetary Theory (1970). The full lecture is well worth a read and available at: https://miltonfriedman.hoover.org/internal/media/dispatcher/214480/full
2 . From 1971 to 1985 PCE inflation and real-estate inflation averaged 6.5% and 7.8% respectively, the correlation was 0.76. From 1961 to 2020 PCE inflation and real-estate inflation averaged 3.3% and 4.6% respectively, the correlation was only 0.36.