The Fed has fueled inflation — and it’s helping the rich

It may come as no surprise that in the aftermath of an epic single-family housing boom and subsequent bust, millions of more people have been renting — without much new multifamily housing supply until recently.

This situation has let to strong gains for apartment REITs and an astonishing ability for property owners to raise rents.

Now a research paper by Rob Arnott and Lillian Wu of Research Affiliates in Newport Beach, Calif. asks why the CPI doesn’t reflect the inflation that is apparent in places where people spend their money.

Arnott and Wu argue that the four biggest expenditures for most people — rent, food, energy, and health care — have been rising. Since 1995, rents have been rising at 2.7% clip, energy at a 3.9%, food at 2.6%, and health care at 3.6%. Notably, these four expenses account for 60% of the aggregate of people’s budgets, 80% of middle-class budgets, and 90% of the budgets of the working poor.

Research Affiliates

Indeed, these Four Horsemen are galloping along, outstripping headline CPI, but it has taken six years of massive government spending, borrowing, and central bank stimulus for real per-capita GDP to regain its pre-recession peak.

In addition, 50th percentile income has barely budged since 1970, and real per-capita GDP continues to outstrip it in a breathtaking manner.In other words, the massive stimulus since the Great Recession of 2008-09 hasn’t brought much benefit to America’s middle class. Rather than unleashing the “animal spirits” of the private sector, it has arguably served to stagnate economic and wage growth. Monetary policy, in particular, may be stimulating inflation in financial assets including stocks, bonds, and real estate — further widening the gap between rich and poor, and hollowing out the middle class, according to Arnott and Wu.

The authors quote former Fed Chairman Ben Bernanke saying he wanted to create a “wealth effect” by lowering interest rates. Resulting higher asset prices would stimulate the affluent to spend more, which, in turn, would have a beneficial effect on the economy.

Unfortunately, spending by the affluent has a limited effect on the economy. Arnott and Wu ask rhetorically, “If the rich mostly buy more assets (i.e., stocks, bonds, real estate, art, collectible cars, rather than ‘new stuff’ that needs to be manufactured), doesn’t that just fuel more bubbles?”

Furthermore, there is a downside to bull markets in that as asset prices soar, future returns diminish. Indeed, looking at the asset return forecasts of Research Affiliates and also of one of the firm’s like-minded competitors, Grantham, Mayo, van Oterloo, it’s tough to find asset classes that are priced to deliver inflation-beating returns over the next seven-to-10 years.

Not only do anemic future returns bode poorly for the wealthy who, Arnott and Wu argue, typically dissipate their wealth among just a few generations. They also harm young workers and the middle class in general who require stronger returns on investments to fund their retirements. The middle class has little incentive to save and invest with prospective returns so poor.

Moreover, new business start-ups are delayed because, with interest rates held artificially low, entrepreneurs don’t know the cost of capital. Near zero borrowing rates aren’t available to them, and the future cost of capital may be still higher.

Likewise, larger corporations shy away from risky projects now in favor of borrowing money at shockingly low rates in order to finance stock buybacks — even if the shares are purchased at ever higher prices.

If monetary policy is artificially propping up asset prices, the good news is that sooner or later prices will revert to levels that more fairly reflect earnings and cash flows. While this will inflict pain on investors, it will also re-set financial assets to deliver more robust returns.