Housing and the CPI
The numbers are in. The Great US Housing Boom has busted. Home prices have declined on a year-over-year (YOY) basis for the first time since the early 1990s. The chart below shows how quickly housing turned from boom to bust.
For intellectually honest economists, this sad situation is no surprise. US housing has shown unmistakable signs of bubble behavior for years. Many, including myself, are only surprised by how long the boom lasted. But the extended nature of the housing bubble means that the bust is likely to be very deep and long-lasting.
We now have a situation where the most important single asset in the economy is in decline, a decline that is expected to continue for a significant period of time. The old saying "As goes housing, so goes the economy" is so intuitively obvious that it is almost cliché. It is difficult to imagine a situation where the debt-saturated US economy could continue robust growth while housing is in decline. There are so many dimensions to this issue that thick books will ultimately be written about the Great US Housing Boom and its aftermath.
Housing is not only the largest financial asset for the average American, it is also the greatest expense. According to government statisticians, the average American spends about 40% of disposable income on housing. Housing expense could be in the form of either rent or mortgage payments. That 40% ratio is used as the weighting for housing in the US Consumer Price Index (CPI) which is the official measurement of the rate of price inflation in the US economy.
Given its prominence, one would assume that the Great US Housing Boom would have contributed significantly to the increase in the US Consumer Price Index. Actually, it has not. The housing component of the CPI is not calculated upon the price level of homes. It is calculated by an indirect measurement called "Owner's Equivalent Rent". Statisticians at the Bureau of Labor Standards (the agency that compiles the CPI) estimate how much a home would rent for on the open market, then use that number to calculate the housing component of the CPI. Historically, rents roughly track home prices although often with long time lags. This methodology is justified in order to make house payments and rent into comparable statistics that apply to all US residents.
The chart below shows an index of the average rent paid by US residents since 2000. These are not actual rental rates but an index representing rent expense. Compare this chart to the chart above for home prices.
We can see that rents have been rising, but at a much lower rate than home prices. Using annual averages, home prices have risen some 45% since 2000. Rents are only up about 16% during that same period. The tame rental inflation rate is thought to be due a glut of rental units that swelled as easy financing enabled many renters to move into home ownership. Although only about 30% of US residents currently rent, it is rental rates that determine housing inflation. As a result, the US Consumer price Index does not meaningfully represent the price of the largest single purchase that a consumer ever makes!
Will home price declines be reflected in lower rental rates? Looking at the rental index, we can see that there is currently no evidence that rents are falling. Think about a renter who is interested in home ownership. The housing bust is now in the nightly news and on everybody's lips. Should a renter take on the risk of home ownership in this market or continue renting and wait for better prices? The collapse in home sales suggests that renters are staying put. This behavior will put a floor under rents, at least for a while. Therefore, the US CPI could still show high levels of price inflation even during a sharp home price decline.
At first glance, this seems to be an obscure technical issue. But the CPI is a critical economic indicator that is used to determine a wide variety of entitlements, interest rates, and policies. The CPI is a core statistic that the Federal Reserve uses to determine monetary policy. Many analysts expect weakness in housing to give the Fed reason to start cutting short-term interest rates as a support for home prices. But a stubbornly high CPI rate could give the Fed pause. Investors, businesses, and consumers have trillions of dollars at stake riding on Fed monetary policy decisions. Housing is particularly sensitive to Fed interest rate policy. Many homeowners have mortgages that are tied to by Fed-controlled interest rates. Fed hesitation at a critical juncture could send an overleveraged US economy into a tailspin with housing leading the way.
Ultimately, rents will regain their historic relationship with home prices. There is currently a large glut of unsold and unoccupied homes. Eventually somebody will occupy these units. Unsold homes and condos may become rental units, adding to the rental inventory which will soften rent prices. But there is an estimated overhang of 1.5 – 2.5 million excess housing units in the US. It could take 3-7 years to absorb that entire inventory. Until then both home prices and rents will be under pressure. But it is likely that rents will hold up better than home prices simply because rents are undervalued relative to homes. If rents hold up, then the CPI will understate the decline in housing.
Look again at the rental index chart. Note the decline in 2002. Although the decline was slight, a 40% weighting gave this component a profound influence on the CPI. This rental weakness was the primary reason for extremely low CPI inflation numbers during that period. In the mean time, many other price indices were still rising strongly including home prices. These low CPI numbers were used as justification for an historic series of interest rate cuts in the wake of the stock market crash and 9/11. In effect, a rental anomaly was used as cover for a financial asset bailout.
The Fed and other government authorities used these and other questionable economic statistics to justify one of the greatest credit expansions in history. This policy was ostensibly imposed to prevent a dreaded "price deflation" similar to The Great Depression. The deflation never occurred. It is debatable whether Fed and government policy actually prevented one. But a home price crash is far more destructive than a stock market crash. The US housing crash in the 1930s and more recently in 1990s Japan proved that point. There is a huge pyramid of financial assets resting upon rising home prices. The mortgage security market alone is over $10 trillion. The entire mortgage market is now vulnerable which creates the possibility of a vicious cycle of mortgage defaults, credit tightening and home price declines. The mortgage security market is international and sensitive to the value of the dollar. The CPI is used as an indicator of dollar value and may not be friendly to another round of credit expansion. Pressure to defend the dollar may thwart efforts to support home prices. In other words, a housing bust will not necessarily lead to lower interest rates and even easier credit.
The story of housing CPI shows the danger of playing statistical games with important economic indicators. It is absurd that home price inflation is not meaningfully reflected in the country's core inflation statistic. The CPI is one of many corrupted economic indicators that is published by the government and is the result of decades of meddling by both national political parties. As a result, all of us are flying blind in a turbulent economy. The statistical machinations that allowed massive price inflation to be hidden in the CPI now allow massive price deflation to be hidden also.
We will soon see if what's good for the goose really is good for the gander.