The Great Inflation Moderation That Wasn't

Since a lot of people are talking about inflation and deflation this week and a lot of people have taken a liking to substituting the Case-Shiller Home Price Index for owners' equivalent rent in the Consumer Price Index as has been done around here for years now, maybe it's time for something a little different.

But first, before moving on, one last quick look back to the now-familiar graphic that shows how badly the Federal Reserve erred a few years back in thinking that "inflation" was either too low (2002-2003) or well-contained (2004-2005) and, advancing to the most recent data to the right, one measure of just how bad "deflation" is today.
As noted when these charts have appeared here previously, in addition to excluding other important homeownership costs such as taxes, insurance, and maintenance, this simple substitution has one other important flaw - it doesn't account for interest rates which, as anyone who has taken out a mortgage surely knows, are a very big factor in determining overall home ownership costs.

In fact, unless you own real estate outright, the first "I" in "PITI" is normally the single biggest component of what it costs to buy real estate.

I was going to say "own" real estate above instead of "buy", but you don't really own anything until you stop paying the "I", after you've whittled down the "P".

That doesn't seem to happen much any more...

Anyway, plotting average 30-year mortgage rates against home prices is pretty easy. That is, after historical data for existing home prices was kindly sent my way a month or so ago.

There are no real surprises below - a big run-up in prices as interest rates were moving lower over the last 25 years with a major price correction at the end that still has a little way to go.
It is through lower mortgage rates that dimwitted economists have sought to rationalize the dramatic rise in home prices over the last few decades, most of them thinking that everything was hunky-dory right up until the housing bubble burst in 2005-2006.

But, as you can see below, after tracking each other closely through the mid-1980s, mortgage rates and mortgage payments then went their separate ways right up until the housing bubble burst when mortgage payments began reverting back to the historical relationship with mortgage rates, aided by plunging home prices.
Of course, you could say that it's not fair to only use the 30-year mortgage rate in these calculations since the wizards on Wall Street have come up with many innovative new ways to finance real estate purchases in recent years, all of which have made mortgage payments much more affordable (for a little while at least) despite the rising prices.

But, then you'd be an idiot.

Anyone could have done the simple math to calculate 90% loan-to-value and then gone ahead and fired up Karl's Mortgage Calculator to see that mortgage payments, when measured in the traditional manner, were going up dramatically as the housing bubble was inflating, something that, in an earlier era, would have been factored directly into the Consumer Price Index.

All of this brings us to the question of what it might look like if, instead of simply swapping out owners' equivalent rent for home prices, mortgage payments were used.

Since owners' equivalent rent wasn't created until 1983, about 11 years had to be lopped off of the charts above to generate what appears below, but it still shows what needs to be shown and, in the process, goes a long way in explaining why we are in such a big mess right now.
First and foremost, this measure of inflation with real homeownership costs included (no, this doesn't factor in taxes, insurance, or maintenance either, but they wouldn't make much of a difference) exhibits much wider swings than the "official" inflation statistics - as high as six percent and then dipping into negative territory on three occasions in 1986, 2001, and in 2008 with the most recent reading about the same as in the Case-Shiller version in the first chart above.

What's the significance of this?

Well, it seems as though the inflation aspect of "The Great Moderation" wasn't so moderate at all if you measure things the way they did back before 1983. Annual inflation rates swinging from zero percent to five percent in a year's time and from five percent back down to below zero are not something that any central banker would be proud of.

And since short-term and long-term interest rates track each other reasonably well over long periods of time, this is largely a result of central bank actions themselves in changing interest rates. It was as if the Federal Reserve was repeatedly whipsawing the economy with interest rate policy while missing important inflation data and not understanding the long-term damage that was being done in the process.

It's no coincidence that, after the events of the last eighteen months, very few now see what was once glowingly called the "Great Moderation" as a permanent shift.

As far as price signals go, it was more like the "Great Muffling".

Comments

[sleepless_o...:]

Excellent article, Tim Iacono.

What is the logic of having Owner Equivalent Rent (OER) rather than mortgage payments in inflation indices? With over 70% (at least recently) of Americans "homeowners" (in quotes, because many are really renting to own) and less than 30% paying traditional rent, this is a major mistake.

It would be much more logical to have the inflation indices use a data point that was 70% mortgage and 30% OER.

Feb 19 09:18 AM

[D. McHattie:]

Perhaps we need to realize that trying to create 1 single measurement for inflation is misguided and overly simplistic.

As you've shown, the prices of various items are often moving in different directions.

Policy should be asset-type (and expense-type) specific, as should our indices.

Feb 19 09:24 AM

[Wide Moat I...:]

First rate work Mr. Iacono.

Re: Kateb. You do highlight the important question goes forward--should the Fed worry about asset price inflation and try to influence it?

One distinction that is crucial. Asset price inflation is not as worrisome in itself. IF it is unemcumbered. The problem is the debt side of the balance sheet. The asset that was inflating was a thin sliver on top of a pile of debt. The sliver grows quickly (relative to initial equity), but can shrink just as quickly. And if it does, then one is left with a giant debt, which will be a significant draw on your future wages. Less future wages means less future consumption.

So the Fed can worry less about asset price inflation and more about debt levels (relative to incomes and GDP).

Feb 19 09:39 AM

[Alex Filonov:]

Honestly, I don't see much difference. At least until 2007. In 2007-2008, deflation would be obvious sooner if Fed used mortgage payments instead of OER.

Feb 19 09:45 AM

[Consider_this:]

I think Housing bubble is different from any other type of bubble, because of the types of participants and how much it affects the base, the fundamental of an economy.

Think back, Compare housing bubble with these two groups.

Group A:
Dot Com Bubble
Telephone Bubble
Railroad Bubble

Group B:
and certain things that started bubble-like, but transformed into real industries:
Internet (arguably the remains from the dot com bubble)
Biotech
Pharma
Software
Processors and Chips
Oil

There's simply no way to tell group A vs group B while the bubble is running.

However, very unlike housing, these bubble, even if they burst, at most hurt the WILLING participants in it and whoever that is funding them.

Housing bubble hurts unwilling participants; either by forcing people out of the market and rent; or force people to stretch their finances, or more accurately, *WRECK* their finances in order to fulfill basic needs. It's also not contained to one sector of the economy, and impact pretty much everyone.

These kinds of bubbles need to be pricked and contained early. Other similar ones that could develop: Food bubble, Water bubble, Credit bubble, etc illustrates what I'm saying, certain things are OPTIONAL, and some are NOT. The basic and non-optional items should not be allowed to bubble and should absolutely be included into the CPI calculation and intentionally pricked.

Feb 19 09:54 AM

[Steve Pasq:]

Very interesting charts. Has anyone seen an historic chart of the relationship between income and housing prices?

Feb 19 09:57 AM

[Alphameister:]

Very insightful analysis! Generally good comments as well. The more pertinent current question would appear to be whether the Fed should worry about asset-price DEFLATION and try to influence it.

Feb 19 10:13 AM

[Leftfield:]

The point above by Wide Moat makes sense to me. Debt expanding rapidly to inflate a bubble is particularly bad. Particularly, as Consider_This mentions, if it's for basic needs.

Supposedly our well-paid suits-in-charge were looking at all sorts of arcane information and charts to work their wizardry. I guess not.

Feb 19 10:14 AM

[Anandakos:]

Consider,

Railroads are not a "real" industry in your mind? Wow, dude, you must LIVE inside your computer. Without railroads there would have been no oil nor utility industries. You can draw your own conclusion as to whether you would be reading this post yourself.

On Feb 19 09:54 AM Consider_this wrote:

> I think Housing bubble is different from any other type of bubble,
> because of the types of participants and how much it affects the
> base, the fundamental of an economy.
>
> Think back, Compare housing bubble with these two groups.
>
> Group A:
> Dot Com Bubble
> Telephone Bubble
> Railroad Bubble
>
> Group B:
> and certain things that started bubble-like, but transformed into
> real industries:
> Internet (arguably the remains from the dot com bubble)
> Biotech
> Pharma
> Software
> Processors and Chips
> Oil
>
> There's simply no way to tell group A vs group B while the bubble
> is running.
>
> However, very unlike housing, these bubble, even if they burst, at
> most hurt the WILLING participants in it and whoever that is funding
> them.
>
> Housing bubble hurts unwilling participants; either by forcing people
> out of the market and rent; or force people to stretch their finances,
> or more accurately, *WRECK* their finances in order to fulfill basic
> needs. It's also not contained to one sector of the economy, and
> impact pretty much everyone.
>
> These kinds of bubbles need to be pricked and contained early. Other
> similar ones that could develop: Food bubble, Water bubble, Credit
> bubble, etc illustrates what I'm saying, certain things are OPTIONAL,
> and some are NOT. The basic and non-optional items should not be
> allowed to bubble and should absolutely be included into the CPI
> calculation and intentionally pricked.

Feb 19 10:16 AM

[TomF75:]

I have, can't remember where (probably on SA). If memory serves correct trend was generally around 3x (ranging from 2.7 to 3.2) until around 2000 when things went parabolic topping out in the neighborhood of about 4.5. Basically what that means is real estate needs to fall about 40% from top to come back to trend.


On Feb 19 09:57 AM Steve Pasq wrote:

> Very interesting charts. Has anyone seen an historic chart of the
> relationship between income and housing prices?

Feb 19 10:17 AM

[User 74365:]

Excellent points! However, you left hanging out there one big question, as far as I am concerned.
As you have stated, and I have long maintained, the biggest cost component to owning real estate is the interest cost. Viewing your chart of interest rates and home prices portrays this very well.
What I think has been left unsaid, is if you were to estimate just where that interest rate line is likely to go into the future, the resulting impact on home prices, and that resulting inflation/deflation.
I think you'd have to agree that rates have nowhere to go but up over the next few years, given all the needs to float more and more Treasuries to fund this Trojan Horse stimulus plan.
All things indicate that real estate will be a very poorly performing asset class going forward. Something to think about.

Feb 19 10:37 AM

[prudentinve...:]

Let's face it, most people love bubbles, but not their aftermath. Every economists knows that they cannot last forever, and that their end is not pretty. Most of the public with intelligent minds realise this too. But, people love them, and that's why they are a recurring theme in history.

A large segment of the population enjoy easy wealth, the type that comes in bubbles, not the "... we make money the old fashioned way, we earn it." type. (This quote from an ad that used to appear frequently on TV many years ago, if memory serves me, it was Smith Barney who supposedly earned money in this "old fashioned" way).

Politicians love bubbles, as the newly created wealth makes them popular, and some of the easy money inevitably flows their way.

Merchants of every kind love bubbles, as they increase their profits.

The only people who dislike bubbles are those satisfied with moderate consumption, who prefer a modest but stable life. My guess is that these may constitute a large, but unaggressive, "silent majority".

Due to the popularity of bubbles, especially with the aggressive and vocal segment of the population, it takes enormous character and courage from the monetary authorities to prevent them. And all that talk of a "great moderation" was nothing more than a justification by monetary authorities to allow a popular bubble to keep on inflating.

Feb 19 10:38 AM

[Crocodilian:]

There's somewhat less here than meets the eye. Its an interesting article, with a group of interesting statistics, but when you think about them, they're not really saying anything terribly different, rather they're different aspects of what we've long known: interest rates were low, asset prices ballooned, people sought ways to take out equity.


For example:
"But, as you can see below, after tracking each other closely through the mid-1980s, mortgage rates and mortgage payments then went their separate ways right up until the housing bubble burst when mortgage payments began reverting back to the historical relationship with mortgage rates, aided by plunging home prices."

Explained rather easily by the increasing mortgage indebtedness, both in higher loan-to-value of first mortgages, and in various home equity schemes. If the consumer were "using his home as a piggy bank" you'd expect to see exactly this behavior-- in fact, the lower the rates, the greater the incentive to refi/take out a home equity loan.

Similarly, the author makes a point of looking at CPI+mortgage payments and concludes:

"Well, it seems as though the inflation aspect of "The Great Moderation" wasn't so moderate at all if you measure things the way they did back before 1983. Annual inflation rates swinging from zero percent to five percent in a year's time and from five percent back down to below zero are not something that any central banker would be proud of."

Except CPI+mortgage payments are hardly a measure of inflation, for many reasons. The most obvious is that the overall level of mortgage indebtedness changed over time, as did the structure of these mortgages. To simply add mortgage payments to CPI and suggest that this number means something is questionable-- remember, mortgage payments were going up, but so was the offsetting value of the asset owned. There are very good reasons that economists switched to the owner equivalent rents a quarter century ago.

Although most folks are not familiar with "owner equivalent rent", its the right number to use, and is a better reflection of what's going on with housing economics than simply using mortgage payments. I'd also note that variable rate mortgages reset on a six month or annual schedule -- which would naturally result in an exaggerated annual chart seen here, smoothed, the two numbers end up essentially the same.

Feb 19 10:40 AM

[Did U Think...:]

Tim, you use terms like idiot to describe the Keynesian eKONomists. I suggest that anyone who believes them to be idiots is himself an idiot. Is the con man an idiot simply because the patsy does not understand his seemingly irrational behavior? Of course not! The correct description of central bankers and the economists who support them must include words like thief, con man, grifter, financial shell gamer, Democrat, Republicans other than Ron Paul, pump and dump artist, destroyer of lives, reducers of retirements, etc.

They are criminals and only a fool lets them be called something different.

Feb 19 11:11 AM

[Tesa:]

Just assume that interest rates went down and housing prices went up so that mortgage rates stayed constant. There will be a time that interest rates will hit their minimum rate possible after which the real estate prices can only go down to maintain the payments constant.

So the mortgage payments are not a valid gauge for inflation but rather the absolute value of the properties are. The real estate market inflation and affordability are not the same animal.

The manner by which inflation is calculated should account for absolute cash value of real estate and not the mortgage payments.

So I believe that the author is correct.

Feb 19 11:43 AM

[Consider_this:]

Railroad is an industry, of course, but it's nowhere close to what all the investors thought it was going to be when the mania started. It was supposed to rule everything... until automobile came along. In that sense, it has burst; and we have large segments of rail roads built and not really used.

But arguing about this isn't my point.

I am trying to point out that certain bubbles, when burst don't hurt the economy as badly as what we're experiencing now; and some don't really burst much but end up being a long term benefit. Thus, there exists some bubbles that need to be pricked early, and some that don't need to.

Having policy makers make blanket statement that they shouldn't burst bubbles is absurd and irresponsible.

On Feb 19 10:16 AM Anandakos wrote:

> Consider,
>
> Railroads are not a "real" industry in your mind? Wow, dude, you
> must LIVE inside your computer. Without railroads there would have
> been no oil nor utility industries. You can draw your own conclusion
> as to whether you would be reading this post yourself.
>

Feb 19 11:46 AM

[Randy_H:]

>Railroads are not a "real" industry in your mind? Wow, dude,

I was surprised to learn that Telecom wasn't a real industry as well. Who woulda thunk it?

Actually, I think he left out rail and telecom because those weren't simple speculative bubbles -- they were complicated by massive government distortions in the form of how deregulation occurred. Both were previously regulated monopolies. Is it possible to deregulate and break up a gov't supported monopoly without a bubble occurring?

Feb 19 12:02 PM

[John Lounsbury:]

Steve - - -

You can find a chart showing house prices and median family income for the past few decades in: seekingalpha.com/artic...
The graph is fairly early in the article.


On Feb 19 09:57 AM Steve Pasq wrote:

> Very interesting charts. Has anyone seen an historic chart of the
> relationship between income and housing prices?

Feb 19 01:30 PM

[mzzz:]

I wonder how much of the housing bubble issue would moderate if mortgage interest wasn't deductible (the case in many other countries) and maybe some capital gains couldn't be deferred (rolled forward). Now housing looks much less like an investment and more like a place to live, and priced accordingly.

Feb 19 11:53 PM

[Robert H. H...:]

Mr. Iacano -

Thanks for the interesting analyses.

I am not sure that your graph comparing mortgage rates vs. mortgage payments explains as much as you seem to claim.

The increase in the average mortgage payment over your observation period pretty closely matches the increase in the CPI over the same period. So one could as easily conclude that the increasing size of mortgage payments primarily reflects the general level of price increase, or more specifically, the replacement cost of housing.

Over the period 1971 to 2008 inclusive, CPI inflation (all urban) increased by a factor of 5.3x. The data can be found here:

research.stlouisfed.or...

Eyeballing your graph, it appears that the average mortgage payment increased about 5x over the same period.

Also, I'm not sure there's a strong theoretical rationale why the average (or median) mortgage payment SHOULD track mortgage rates, unless you assume constant mortgage balances (corresponding to constant house prices) and a large proportion of variable rate mortgages in your sample.

It seems equally plausible that homeowners select a mortgage payment they can afford (and the bank will allow) and buy the amount of house that payment can support. Under this construct, housing PRICES would be expected to move inversely with mortgage rates, as the same monthly payment would support a more expensive home at a lower interest rate, and vice versa. But mortgage payments themselves would be constant.

I suspect the correlation you see in the mid- to late-70's reflects a "composition effect" as double-digit mortgage rates during this period pulled the average up from 6% mortgages that were available in the 60's.

Although nominal interest rates were high during this period, real interest rates were not; and the housing market, while volatile, was generally strong as it was fueled by the first wave of baby boomers entering the market. As a consequence, during the inflationary 70's, when an existing house was sold, the mortgage on that house quite possibly stepped up by 800-1000 basis points. The payment would increase proportionately even if the house price had not changed from the last sale.

Feb 22 05:06 PM