What the Fed Can Learn From the U.K.’s 1991-92 Recession
A key data point used to measure inflation in the United States rose at its highest pace in over three decades last week. The core personal consumption expenditures price index, which tracks changes in the cost of goods and services, climbed 3.4% year-over-year in May, its highest reading since 1992. While the Federal Reserve continues to believe that price pressures showing up throughout the American economy are transitory and should largely subside by the end of the year, there is more data coming out that rising prices may be here to stay.
What is happening in the U.S. in 2021 is very similar to what occurred in the United Kingdom in the late 1980s and led to a recession in Britain in 1991-92. The U.K.’s economy in the late 1980s was defined by high economic growth and rising inflation, known as The Lawson Boom, named after Nigel Lawson who served as Chancellor of the Exchequer during the majority of the 1980s. By the middle of the 1980s the U.K. was growing robustly, unemployment was on the downslope, and inflation was below 2.5% per annum.
Lawson allowed the U.K. economy to expand faster than its long-run trend growth rate primarily by keeping interest rates low. This was before the Monetary Policy Committee at the Bank of England set baseline borrowing rates. This helped to increase consumer spending and fueled a booming housing market. The rapid increase in the British housing market led to a rise in consumer wealth and spending, fueling consumer confidence and growing housing prices even further. The U.K. government at the time was under the impression that the economy was growing primarily due to supply-side factors, when in hindsight it turned out that the majority of its economic growth was being driven by consumer borrowing and debt-fueled spending.
This was reflected in a large current account deficit that the U.K. ran in the 1980s and rising inflation during the latter part of the decade. For reference, the U.S.’s current account deficit increased to a 14-year high in the first quarter of 2021. Also, the American economy currently has inflation trending at well over 3% year-over-year after averaging annual inflation of about 2% in the 2010s and running inflation at on average 3% over the past 100-years.
In order to tame inflation, the U.K. was forced to rapidly increase interest rates in the early 1990s. This led to a rise in borrowing costs and a rise in mortgage interest payments resulting in a reduction in consumer disposable income and a fall in aggregate demand. Housing prices subsequently started to fall rapidly as homebuyers and investors could no-longer afford their mortgages and were unable to make larger down payments on new investments that were now needed as required debt service coverage ratios (DSCRs) remained constant, but interest rates increased.
A DSCR is a measure of cash flow available to pay current debt obligations. As interest rates increase lenders are willing to give less money to borrowers as they look to maintain a minimum DSCR when lending on assets.
While there are some differences, the primary factors that led up to the U.K.’s 1991-92 recession are very similar to what is taking place in the American economy today. The Federal Reserve’s accommodative monetary policy to bring the U.S. to full employment has also created one of the hottest housing markets in the country’s history. The median selling price of a home in the U.S. is up over 25% from a year ago and rose above $350,000 for the first time ever. While this is partially being driven by a shortage of new homes being built, low interest rates combined with household savings being at record levels are also driving real estate prices to stratospheric levels. U.S. household wealth jumped to a record $136.9 trillion per the latest set of available data.
Also, similar to what took place in Britain in the 1980s, the U.S. is experiencing high levels of inflation that are running near-or-above trend growth. The Federal Reserve’s initial stance on inflation was that it was the result of all the consumer demand coming back online in the wake of the Covid-19 pandemic, but many economists believe that the cat has already been let out of the bag.
Famed economist Mohamed El-Erian said earlier this week, “I have concerns about the inflation story. Everyday I see evidence of inflation not being transitory, and I have concerns that the Fed is falling behind and that it may have to play catch-up, and history makes you very uncomfortable if you end up in a world in which the Fed has to play catch-up.”
If the Federal Reserve ends up having to scale back asset purchases and increase interest rates faster than it anticipates in an effort to catch-up to inflation, the consequences may be dire for real estate, just like they were for British real assets when the U.K. had to rapidly increase interest rates in an effort to stem inflation in the early 1990s.
High interest rates in the late 1980s/early 1990s in the U.K. caused a rise in foreclosures across property types. A similar situation would likely occur in the U.S. if the Fed were forced to raise interest rates quickly in an effort to stem price increases. If inflation in America turns out to be more permanent than the Fed is currently forecasting, U.S. property investors should be on the lookout for distressed buying opportunities.
Distressed acquisition opportunities are most likely to occur in already struggling property types, i.e. Class B and C office and retail assets. Though, over the coming months buyers should start to be on the lookout for assets across property types that were bought at a high-basis, have struggling fundamentals, and have the term on their debt expiring in the next year or two. If inflation takes hold and interest rates start to creep up, lenders on these assets will begin to cut off the spigot and may not allow owners to refinance out the proceeds needed to pay down the outstanding principal balance on a property’s mortgage.
Also, a worst case scenario would be that interest rates start to rapidly creep up as the mortgage and rent moratoriums expire at the end of July. This may open up a window for buyers of workforce and affordable housing properties to get into assets at a much lower basis than they would have been able to just a few months ago. Many non-institutional owners of these types of properties are depending on arrear payments coming in to settle up on missed debt payments. Tenants who have not paid rent in over a year, may have a difficult time coming due on their outstanding rent obligations that are needed to help properties stay afloat.
If inflation turns out to be more enduring than the Fed expects, hopefully they are able to heed the lessons of history and get out in-front of price increases before it is too late. Playing catch-up can be a dangerous game.