Housing Prices and Inflation

In Sunday's NY Times Daniel Gross writes an interesting article How Home Prices Can Be Hot but Inflation Cool (free registration required) discussing housing prices and inflation.

In other words, a home isn't just where you hang your hat or an investment in the future (or, in the case of visitors to CondoFlip.com, for two days). It's something that is consumed, the way potato chips, gasoline or a barber's skills are. So the bureau decided to track a measure that represents only the consumption of housing: rent. And rents had much to recommend themselves as a long-term inflationary yardstick - they don't jump significantly from month to month - and as a proxy for home prices. Over time, after all, rents correlated very closely to home prices.

As the article points out, rents have decoupled from housing prices. And as the article further points out, more and more people own homes, thus making "rent" less significant. As rates decreased, housing prices increased, which in turn encouraged a strong housing building boom. The building boom drove rents down as people left their rental accommodation to gain home ownership. As rents went down, inflation was reduced because of the reliance upon the rental input. But in reality, inflation was rampaging along as housing prices and commodities (cement, lumber, copper, and others) went ever higher. Oddly enough, the more extreme this cycle became, the more tame inflation appeared.

What would happen if Greenspan were to suddenly raise interest rates much beyond people's expectations? The overall economy would slow because of increased interest rates. Because of rising interest rates many of those who have ARM mortgages would be forced to liquidate, perhaps at a substantial loss. Housing prices would decline because some people could no longer afford their mortgages and because of declining housing speculation. Those who would lose their homes because of expensive mortgages would become renters again. And because of increased demand, the rental market would tighten and rents would rise. Oddly enough in this scenario, higher rents would result in higher inflation, even though housing prices might be plummeting and the economy slowing.

Both situations seem counterintuitive. The first situation arises because lower rates cause renter to purchase homes, driving up home prices. In this situation, rental rates drop. The second situation arises because interest rates force many people out of their homes and back into the rental market again. Housing prices drop, perhaps significantly, but rental markets strengthen.

So when you hear inflation numbers being low, remember that roughly one quarter of the inflation figure results from the rental market and that rental market might be moving in the opposite direction to the prevailing change in inflation.