Will Lower Rates Tame Inflation? BlackRock Thinks So.

But they could just be talking their book

It’s Friday, a perfect day to float novel economic theories like “low interest rates actually make things cheaper.”

Which seems crazy, but according to BlackRock’s head of global fixed income, Rick Rieder, it’s sound economic theory.

And pretty much flies in the face of everything we thought we knew about interest rates and the economy, and the way the Federal Reserve talks about how the rates they set impact inflation.

So does he have a point?

According to Rieder, high interest rates benefit higher income Americans, especially those over 55, who earn more on fixed income investments. In his Bloomberg interview, he went on to say that the demographic has used their extra income to push up the prices of services.

Which isn’t an unreasonable premise.

But Rieder also said that “Because goods prices have come down so much, it's allowing for disposable income to go into services. That's actually buoying prices in services. The price of a pair of tennis shoes is what it was 20 years ago. If you go to a tennis match, it's double what it used to be.”

That’s a pretty surprising statement from someone who is supposed to be paying attention to the economy.

Tennis shoes, televisions and luxury other goods haven’t seen much inflation over the past couple decades, but what about food over those same 20 years? Which it turns out people need more than tennis shoes.

Milk: +30%

Eggs: +115%

Chicken: +82%

Not sure Rieder’s theory holds up there. Ditto things like housing, education, healthcare and just about everything except things like tennis shoes.

And on the same day, two reputable economists suggested that the Fed should strip out housing costs of the inflation measures it uses when setting monetary policy.

I understand the argument to a point, since the way the Fed calculates is backwards looking and deeply flawed, but to strip it out sounds a bit extreme. Why not just improve the measurement process?

I bring this up because I am starting to hear a chorus around the finance and housing world that lower rates could be good for housing costs. In other words, they’d start to come down.

Like BlackRock’s Rieder, this sounds a lot like people talking their book. (Meaning, if your portfolio or business benefits from lower rates, why not jawbone a bit in the hopes of pushing sentiment in that direction.)

The logic goes that lower financing costs will be spur development, and more supply would help bring down housing costs. On the surface this seems defendable.

But when you dig into the actual costs of building housing, the argument falls apart.

I created a back of the napkin pro forma for a theoretical housing development to evaluate the impact of higher interest rates.

The following basic calculation assumes a construction financing cost of 5%, which is about right during the era of low interest rates (some certainly borrowed for less, but let’s go with 5% for now).

It also assumes $400 per foot construction costs and 20% on top of that for soft costs, which is directionally accurate for some of the higher costs building regions in the US which face the biggest supply crunch. In some cities like San Francisco and New York, the cost is actually much higher.

As you can see, financing costs are the smallest line item of the major development costs - land and construction. Between hard and soft costs, construction is over 80% of the project’s budget.

The exact percentages will vary by region and project type, but in all cases construction makes up the lion share of project costs.

Under the scenario above, the developer would book a profit of around $6.3MM.

If rates rose ten percent to 6%, the developer’s profits would tick down to $5.7MM. And if they rose twenty percent to 7%, profits would come down to $5.1MM.

Which hurts, but in and of itself is probably not enough to kill a project that otherwise looked good.

What has actually crushed housing development is higher construction costs (materials and labor), and increasingly challenging municipal bureaucracies and local organizations who oppose the creation of more housing in their back yard.

The latter is a subject for another time.

On construction costs, a ten percent increase in costs whacks profits to $2.0MM, and a twenty percent increase takes the project into the red with a loss of $2.2MM.

Would lower rates help ease the housing supply crunch? No doubt.

But its folly to think that the inflation caused by loose monetary policy won’t keep making housing ever more unaffordable.