This post first appeared in the SPECIAL EDITION: Cirios Trends: A Decade in Flux

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At the heart of some of the most contentious debates in the otherwise drab world of macroeconomic theory is that of inflation (yes, there are in fact contentious debates about macroeconomic theory). To wit, economics can’t even agree on a definition for the term.

The laymen understanding of inflation is the rising of prices. Some economists agree, while another camp argues that higher prices are merely one of many signs of inflation, which they define as an increase in the supply of money within an economy.

Commonly, inflation is measured by the Consumer Price Index, or CPI, which purports to be a representative basket of goods and services that reflects what the average consumer buys with his or her hard-earned dollars. And while there are myriad criticism of the CPI and how government bean counters arrive at the final tally, that is a debate for another forum.

Suffice to say, as can be clearly seen below, prices in the US have been steadily rising for about as long as anyone can remember. And as some generations remember better than others, during the 1970s and 1980s, prices rose rapidly indeed.

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Most credit then-Federal Reserve Chairman Paul Volcker (currently the chairman of President Obama’s Economic Recovery Advisory Board) for breaking the back of inflation in the early 1980s with a hard-line policy of high interest rates. High borrowing rates discourage investment, curtailing economic growth, which can slow the pace of rising prices. This politically unpopular monetary policy led to persistently high unemployment and a deep recession, but ultimately inflation was brought under control.

Since Volcker’s tenure as Chairman, successive Fed Chairmen have kept interest rates low, while presiding over a period of slowly rising prices. While this sounds like a perfectly healthy economic balance, many argue this “balance” fostered the eventual imbalances that threw the global financial system into such wild disarray.

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This post first appeared in the SPECIAL EDITION: Cirios Trends: A Decade in Flux

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It stands to reason that falling interest rates leads to higher home prices. After all, for every one percent drop in mortgage rates, buyers can afford around 10% more house. Against that backdrop, the chart below makes sense: After sky-high interest rates of the late 1970s and early 1980s, a consistent decline in interest rates helped usher in an historic increase in home prices.

But, as is often the case when complex macroeconomics are at play, there’s more to the story.

In order to fully understand what on the surface seems like a relatively straightforward relationship, we need to more fully understand what moves mortgage rates, which have such a direct effect on home prices.

Since it’s creation in 1913, the Federal Reserve has been charged with overseeing our nation’s monetary policy and maintaining price stability. Chief among it’s responsibilities is to set the “Federal Funds Rate,” which in simple terms is the rate at which banks lend to one another. Virtually all other borrowing rates are pegged at some “spread” above this baseline rate, based on the perceived riskiness of the loan.

With this tool, the Fed tries to maintain the modicum of inflation it believes strikes the proper balance between economic growth and stable prices. Lower rates encourage growth but push up prices, while higher rates curtail rising prices but at the cost of retarding economic activity.

However, with the Full Employment and Balanced Growth Act of 1978, Congress tacked on another mandate to the Fed’s list of tasks: “long-run economic growth.” The seeming contradiction of “stable prices” and “economic growth” is at the root of the debate over the role of the Fed in our economy.

So, using the logic laid out above, Paul Volcker and his inflation-crushing high interest rates of the 1980s should have sent home prices tumbling. Why then did home prices keep on rising during this period of high mortgage rates? Read on to find out.

(click to enlarge image)

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