The Ghost of LBJ
by Jim Scott

Or how will the widely expected period of increasing inflation affect your real estate? Like it or not, all signs indicate that the era of cheap prices, oil and money is over. We are already witnessing the first stages of the disease, progressively creeping interest rates. This traditional cure, as administered by the Federal Reserve Board, will directly affect housing markets as well as other segments of the economy. All significant economic changes create unwitting winners and losers. There are some strategies that you can implement today to protect your real estate assets, assuming you believe in this inflationary-driven scenario.

How Did We Get Here?

Real estate owners, both commercial and residential, have benefited from this period of historically cheap money. When the national economy slipped into recession in 2001, the Fed used low interest rates to right the economy and reduce unemployment. The latter did not occur immediately due to globalization and job outsourcing, excess industrial capacity and productivity gains. The San Diego economy avoided the recession, allowing us to exist in an economic fantasy world--regional job growth and a booming real estate market both driven by cheap money. The first-time purchaser discovered buying a condominium was cheaper than renting.

This year the nation's businesses grudgingly started to add jobs. The price of oil reached $42 per barrel. Taxes were cut without compensating revenue offsets and the Treasury had to borrow money to finance the growing deficit. And then the war. When Alan Greenspan announced last month that the period of “accommodation” was over it was already old news.

Guns and Butter

Increasing demand for goods and services translates into borrowing. Business, consumers and the government are sidling up to the money store with outstretched palms. The price of money goes up with increased demand. Mortgage lenders add in an inflation premium. Housing, and other goods and services become less affordable. This is where Lyndon Johnson comes into the story.

Our 36 th president had his war and chose to finance it by borrowing and not taxing. In 1973, just after we withdrew from Vietnam , the price of oil quadrupled overnight. This set the table for double-digit inflation that plagued the Ford, Carter and Reagan years. The war ended and the bills came due. Sound familiar?

The Rest of the Story

The presidents noted above were left with the job of stuffing the inflation genie back in the bottle. In the end it took Paul Volker, then chairman of the Fed, to slay the dragon. He raised the prime overnight to nearly twenty percent. I remember purchasing four units in Pacific Beach in 1981 with a 17.5% fixed rate mortgage. This was pure monetarism in action; control inflation by restricting the supply of money and therefore driving up interest rates. Today the Board controls inflation differently by making small adjustments to the one rate they control. This has a direct impact on short-term rates that set variable rate mortgages. Long rates, like the price of 30-year fixed rate mortgages, are more influenced by our collective fear of inflation. The good news is that the current chair of the Fed does not believe in the Volker method. There will be no cold turkey for us. He will make small changes to nudge rates. It will take longer to get where we should be, but this is an election year.

Keep an eye on the 10-year treasuries that set the price of the traditional 30-year fixed rate mortgage. In mid-2003 when rates hit historical lows, the yield of 10-year treasuries was 3.11%. As of this writing, the yield on this key instrument is approaching five percent. It looks like the bets are in; lenders see higher prices of goods and services in the medium and short term.

No one knows the full price of the war on terrorism now and in the immediate future. The effort to make our world safer is going to cost a lot of money. I suspect the era of cheap money is over until we either pacify the Middle East or raise taxes. You can make your own call on that one.

Some consumers are still acting like we are awash in cash, like Uncle Scrooge bathing in his money bin. But that does not square with the reality of our future. You can still be a winner in an inflationary period. The trick is to get positioned today in anticipation of a period of higher interest rates and prices.

Read Jim's back articles at www.sqre.com or call him for selected back issues, 619 920 9511

I welcome your comments; my email address is jimscott@sqre.com.

You can reach Jim Scott at his office, conveniently located in the heart of Mission Hills, at 1111 Fort Stockton Drive. Founded in 1982, Scott & Quinn is the oldest full service real estate firm in Mission Hills and is still locally owned and operated. Jim has been a homeowner in Mission Hills since 1976. He is married and has two boys. He can be reached at 296-9511, extension 100. Scott & Quinn features professional property management as well as 15 sales associates. Click here to see Jim's past Market Reports .You can also download Jim's 26 page research paper on San Diego County apartments.