Let’s Talk About Everybody’s Favorite Subject: Inflation. (cue the orchestra…)

What is Inflation?

A subject that comes up in times of economic prosperity as well as turmoil. It's a standard measurement for the health of an economy and impacts every person in similar ways.Basically, inflation is represented by how much purchasing power a dollar (or any currency) has over a specific time period. If the value of that dollar is falling because the price of goods and services are climbing, that's inflation. (Big surprise, deflation is the reverse: the value going up while prices decline.)The rate of inflation is dictated by indices such as the Consumer Price Index (CPI) and is made up of a specific set of goods. More on the CPI in a moment.

Types of inflation.

There are three types of inflation that are widely understood and agreed upon:

• Demand-Pull
• Cost-Push
• Built-In.

How does inflation impact real estate investing?

Put simply, if prices of goods and services are going up, then the cost to borrow money goes up in tandem. This typically means fewer house purchasers and a greater number of renters. For the investor, if you’re putting your money into a leased unit while overall prices continue to climb this can be a strong opportunity as demand increases for rental properties, both residential and commercial.What might this mean for the purchase of you next investment property? Often, when you purchase investment real estate, you leverage a portion of the purchase price from banks. Say you purchase a property in 2021 for $2,000,000 using both $400,000 of your own cash and leverage (borrow from the bank) $1,600,000.Then, let's imagine that inflation rises 3% between ‘21 and ‘22. The value of your property in 2021 would be $1,060,000 ($1,000,000 – original purchase price plus $60,000 due to inflation). Inflation has just created an additional $60,000 in equity for your investment. For this and many other reasons, real estate can often be a safe place to be in inflationary times.

Who determines how much a dollar is worth?

Actually, the question uses the wrong interrogative. It used to be a ‘who’ question, but has moved toward a ‘what’ in determining the value of a dollar.And the answer to that is many things. Basically the demand for it in the value of goods and services. Interestingly, the value of a dollar is often determined by its strength in purchasing foreign currencies. This is represented by an exchange rate.Secondarily, the value of US Treasury notes is important as they can easily be converted and if the demand for those notes is high, the U.S. dollar value rises.Lastly, how much in U.S. dollars is held by foreign governments plays a role. If they are holding onto a large amount, then supply is lower, making U.S. money more valuable.Most importantly, it's critical that the U.S. dollar maintains a balance in terms of its value. An increase isn't necessarily good and can lead to deflation as prices and values of things drop (such as housing).A decrease in value over time gives us the inflation, discussed above. It's up to the Federal Reserve to keep an eye on things and adjust the supply of money or interest rates to keep inflation in check. A common belief is that a healthy economy continues to thrive even with a 2% rate of inflation.

How much is dollar worth? CPI (Consumer Price Index).

What is the CPI? - The Consumer Price Index, or CPI, helps determine the relative value or strength of a U.S. dollar. Because of this the CPI is one of the most closely watched national economic statistics. The Consumer Price Index is a weighted average of the cost of a general pool of goods or services purchased by a typical household.It's based on statistical estimates using the sample prices of items representative in that pool and which are measured consistently and periodically. Food, housing, energy, healthcare, and more are all categories within that pool.Sub-indices and sub-sub-indices can be computed for different categories and sub-categories of goods and services, being combined to produce the overall index with weights reflecting their shares in the total of the consumer expenditures covered by the index. It is one of several price indices calculated by most national statistical agencies. The percentage change in the CPI is used as a measure of inflation (or deflation) and can be used to ‘index’ or adjust for its effects, such as the value of wages, salaries and pensions, and to regulate prices.In most countries, the CPI, along with the population census, is one of the most closely watched national economic statistics.

Alternative measurements to CPI.

Critics of the CPI argue it overstates inflation by as much as one full percentage point each year. Because of this, alternative measurements do exist but have their own drawbacks, ultimately resulting in CPI continuing to be the most reliable indicator of changes in inflation.The Producer Price Index (PPI) published by the US Bureau of Labor Statistics calculates production of goods and selling prices over time from the standpoint of the producer, manufacturer or provider as opposed to the CPI, which is a measure of consumer purchasing power.The Bureau also measures something called the GDP Price Deflator. The GDP, being the Gross Domestic Product. It combines the changes in prices of all goods and services at a total economy level. It helps economists compare yearly changes in the health or activity of an economy and it's considered more comprehensive than the CPI because it isn't limited to this fixed pool of goods and services previously mentioned.Still, most experts, economists, media entities, and financial prognosticators defer to the CPI as the “index of choice” due to its history and general acceptability as an accurate and readily understandable (to the layperson) measurement of the health of an economy.

What is an index.  

It's not your parents Dewey Decimal System that's for sure.An index, such as the CPI, or PPI we talked about here, is all about grouping assets, goods, services, production output, etc. into a generally acceptable measurement using a standardized metric and methodology.The grouping aspect is important in that it prevents any single issue, asset, currency, or other, from over-impacting the result of the index in total. For example, for CPI, should the impact of housing costs dramatically change (as in 2008), the CPI would take that into account but not to the relative detriment of the other goods or services represented in the basket. Not an average, per se, but a collective measurement that represents the overall CPI and therefore health of our economy.

References:

• US Bureau of Labor Statistics:  Overview : Handbook of Methods: U.S. Bureau of Labor Statistics (bls.gov) 
• https://www.investopedia.com/terms/i/inflation.asp