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by JamesBarney
2163 days ago
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One of the biggest issues with deflation is it creates a high floor on interest rates. Even if the nominal interest rate was 0, the real interest rate would be 2% severely limiting the Fed's ability to fix recessions. The current federal funds rate is 0-0.25% and with an inflation rate of 2% that gives us a real interest rate of -2%. If we had 2% deflation then the real interest would be 2%. That's a 4% difference in interest rates, which is huge. The demand destruction comes from individuals and corporation saving more money instead of spending or investing it because they get a 4% better return in one scenario than another. The biggest purchase individuals make is buying a house. Surely you can't argue that paying a 1-4% higher interest rate on a house wouldn't noticed by consumers. |
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That depends on how house prices are determined.
If houses are priced primarily based on the cost of construction plus the cost of materials, you would expect consumers to notice a significant difference in total cost under high vs low interest rates, since the base price of the house will be the same either way and a higher interest rate will lead to a higher total cost.
If houses are priced by people looking at what the maximum monthly payment they can afford is, and are bid up to whatever that maximum monthly payment is, people will just observe that houses cost "almost more than I can afford" no matter what the interest rate is. Lower interest rates will lead to higher prices (capped at 360 (30 years x 12 months per year) times what people can afford, at 0% interest rates), and higher interest rates will lead to lower prices (down to the floor the principal being the of cost of construction).
I think most housing markets are more like the first scenario than the second, at this time, but it is entirely plausible that this won't always be the case, and some would argue that e.g. the bay area housing market already more closely resembles the second scenario.
Edit: typo