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There is a debate brewing among high-profile economists over inflation and its impact on the economy, and the housing market in particular. In April, Paul Krugman wrote a piece in the New York Times criticizing Federal Reserve Chairman Ben Bernanke for not fully acting to fix the economy.

To understand the debate you need to understand the Federal Reserve Bank itself.

The Federal Reserve Bank's Dual Mandate

Since its inception, the Federal Reserve has had a dual mandate to lower unemployment while simultaneously keeping inflation under control. This mandate is derived from the theory of a negative correlation between inflation and unemployment.

This negative correlation between inflation and unemployment is sometimes represented by the Phillips Curve.

(click to enlarge)

This dual mandate at the Federal Reserve is both controversial and compelling. Many people do not think that you can control unemployment by changing monetary policy. Some people think that there is absolutely no link between employment and inflation.

Inflation as a Boost to Employment

Typically, you might say that inflation is a product of increased employment. When employment rises, so does consumption of a limited number of resources, which pushes up prices. However, I would make the case that increases to inflation would actually help to improve employment as well. Here is how:

  • Inflation is nothing more than the devaluation of the U.S. Dollar.
  • Devaluation of the dollar also devalues financial products that are denominated in fixed terms. This includes things like certificates of deposits, loans, and mortgages.
  • Fixed value financial products, such as mortgages, would be reduced in real value, through the devaluation of the dollar.
  • Real assets, such as real estate, would increase in value or stay the same in real terms. If the value of tangible assets is growing and the value of intangible assets is decreasing, then equity is being created.
  • When equity is created, it is reinvested, or spent. This behavior spurs demand, which further pulls on inflation.
  • Increased demand boosts production and this boosts job creation.

Real World Example

A farmer owns hundreds of acres of land on the edge of suburbia, where he grows corn. Commodities prices have been rising (due to inflation) and the farmer is making a nice profit selling his corn. A real estate developer believes that the land could be turned into a residential neighborhood and offers the farmer a very large sum of money for the land. Since corn prices are rising, the farmer decides not to sell this year. As a result, the developer is unable to build new houses.

The lack of available homes under construction limits supply on the market. Limited supply forces home buyers to buy existing homes, including foreclosures, sopping up excess inventory. As supply becomes limited, bidding wars drive up the price of residential real estate.

A homeowner who lives in the same school district as the farmer wants to open a small business. After speaking with her credit union, she finds that she has home equity and uses it to open a line of credit. Thus inflation of commodities prices indirectly propped up the price of many different assets, which in turn spurred economic growth.

Who Might Benefit from Inflation of Home Prices

Mortgage insurers like Radian Group Inc. (RDN), MGIC Investment Corp. (MTG), and Genworth Financial Inc. (GNW) would benefit from rising home prices. In fact, if home prices rise fast, the companies might find they have fully reserved for losses.

Last February, five major banks settled with State and Federal authorities over bad foreclosure practices. The banks involved with that settlement are Bank of America (BAC), JPMorgan Chase (JPM), Citibank (C), Wells Fargo (WFC) and Ally Financial (ALLY-PA). Where there are lots of foreclosures, there is an opportunity to reverse losses through increased home prices.

Finally, Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) were holding 180,000 REO properties at the end of 2011. Inflating home prices will not be the magic bullet for Fannie and Freddie, but it may be enough when combined with an actual plan, like the one proposed by Jim Millstein, architect of the AIG bailout.

Lastly and most importantly, homeowners would benefit from moderate inflation, especially when their homes value is less than the stated value of their mortgage.

Source: Why Inflation Could Give A Boost To The Economy

Additional disclosure: I am long the GSE preferred stocks only.