Inflation: A Cinnamon Roll Story Pt 2

In our last article, we explored home price increases over the last two years. Today we will address the questions we ended that article asking why are prices so much higher and what should we expect going forward?

As we briefly mentioned, we begin answering these questions by examining two basic economic drivers: supply and demand.

Let us first consider supply. The quantity of homes on the market plays a role in the price those homes can dictate. Consider this silly example to better understand this impact. Every year at our local Apple Festival, I buy at least one cinnamon roll. Imagine I arrive late to the stand, am third in line, but there is only one roll left. What might the seller attempt to do to the price of that cinnamon roll? With a limited supply, the seller may increase the price to see who most wants the roll. Similarly, if the market experiences a shortage of available homes, sellers may increase prices. Matt Kinghorn, with the Indiana Business Research Center, reported on Indiana’s supply situation, saying, “the state’s so-called months supply of inventory measure fell below one month…and bidding wars became the norm as the state’s average sale price for existing homes exceeded the list price.” (Indiana Business Review, Volume 96, No 4).

Demand is a bit more complicated. 30 years ago, 1992, the average individual could get a mortgage with an interest rate of 8.39%. If I borrowed $100,000 for 30 years, my monthly payment came to $761.13.

Today, a borrower could borrow $172,500 for 30 years at that same monthly payment. Why? Today’s 30-year interest rate is approximately 3.375%. Back to the cinnamon roll, if I have $10 in my pocket, I’m limited to that price in the market. If, however, I have $100, I dramatically increase my ability to demand the product no matter the cost. Low interest rates give borrowers greater buying power.

We now can better understand why prices increased dramatically over the last two years. Low supply coupled with historically low interest rates resulted in unprecedented home price appreciation.

Because this increase is primarily economic, will it continue? It is important to note that there is a difference between economic-driven price growth and value-added price growth. Back to our cinnamon roll: If the stand develops a larger roll, they can charge a higher price. This is value-added. However, every homeowner did not add double digit percentage improvements to their home. Therefore, the price increases are much more transient and market driven.

Supply issues will not correct themselves in one year, and we should not expect supply to improve dramatically soon. This will keep home values elevated. The Federal Reserve anticipates three rate hikes in 2022. Whether we get one, four or none remains unknown. If rates trend higher, they will slow demand and home prices will stabilize or potentially decline. Prices, regardless of rates, will likely remain elevated through 2022.

Joshua Riggins is the president of Farmers & Mechanics Federal Bank in Bloomfield, and is committed to providing customers with a reliable and competent banking experience.