If the dual mandate of the FOMC is full employment and stable price (i.e. fighting inflation) and the FOMC’s preferred measure of inflation, the core personal consumption expenditures price index (“PCE”) is tipping downward by their own admission, why is the FOMC continuing on their tightening path? Well, the FOMC’s Philips Curve models say so. Named after a British economist named A.W. Philips, the Philips Curve suggests that there is an inverse relationship between unemployment and inflation. As we approach what the FOMC considers full employment, the members expect that inflation will start to pick up. In anticipation, the FOMC has embarked on a path of reducing monetary accommodation. The Committee has raised the target range for the federal funds rate by 25 bps twice already in 2017 with the expectation of one more 25 bps increase before year-end. In the past two meetings of the FOMC, there have also been detailed discussions about the timing and pace of a balance sheet normalization program to begin in 2017; in a recent appearance on CNBC, former FOMC chairman Ben Bernanke talked about a target of $2.5 trillion from the current levels of $4.5 trillion.
In the June 17th Barron’s, there was an article titled “Is the Federal Reserve Living in the Real World?” suggesting that the FOMC may be underestimating the deflationary forces stemming from technological disruption that are driving down prices and wages. Take, for example, the $13.7 billion acquisition of Whole Foods by Amazon, which was announced a few days after the FOMC meeting where the Committee members were deliberating over inflation reading that were stubbornly lower than their expectations. Well, Amazon’s merchandise margins (excluding AWS, their cloud business) are about one-third of the typical retailer gross margins; will prices at Whole Foods go up or down subsequent to its acquisition by Amazon? Revenue per employee at Amazon is approximately 10 times the revenue per employee at Whole Foods. Will Whole Foods operate with more or less people at its store subsequent to its acquisition by Amazon?
While globalization may still be the deflationary boogeyman in many parts of the US, the effects of technology will most likely prove more pernicious on wages and prices going forward. It should not be at all surprising that whispers of “universal income” are emanating from Silicon Valley.
So what does this mean for commercial real estate? Well, good news for the denominator; cap rates should stay low (if the above scenario holds true), supporting asset prices. It may be a more nuanced story for the numerator. Oversupply should be avoided at all costs as demand (most likely correlated to GDP growth) will not be particularly robust. In the same vein, landlords benefitting from secular demand drivers should outperform those looking for a cyclical uplift. Finally, quality of location is paramount. Even in a property type like retail which is under duress, it is noteworthy that Amazon chose to take on the real estate liabilities of Whole Foods rather than those of Kroger or Safeway.