U.S. Housing Market Flirting with Deflation

by: J.D. Steinhilber

Over the past two months, inflation data have been almost uniformly above expectations while growth reports have been largely disappointing. This trend of weakening growth and accelerating inflation is unmistakably stagflationary, which is the worst possible environment for financial assets. Moreover, these conditions may persist in the months ahead, with economic data likely to weaken further and inflation pressures unlikely to ease in the near term.

Although retail sales were solid in July, a retrenchment in consumer spending appears underway. Discretionary income growth (i.e. disposable income less spending on essentials such as energy, interest payments, food and medical costs) has turned negative for the first time in over 15 years, while the correction in housing is still in its early stages.

With respect to the inflation backdrop, we now have a situation where the U.S. housing market is flirting with deflation for the first time in 15 years, while inflation is increasing elsewhere in the economy. Widespread inflation pressures in the economy have been obvious for several years, but they have finally begun to show up in a pronounced way in the government’s measures of “core inflation,” all of which has recently spiked to multi-year highs and are running above the upper boundary specified by the Federal Reserve.

After registering double-digit annual price appreciation as recently as January, the median U.S. house price is now flat on a year-over-year basis. Based on current record levels of housing inventories and pressures on discretionary income, the housing data are on the verge of registering year-over-year
price depreciation. This development would come as a rude awakening to households who generally regard housing as immune to nominal price declines.

The flaw in the consensus analysis that home prices can only go up (particularly in light of the current environment of still-low mortgage rates and low unemployment levels) is that it fails to account for the sizable overshoot in home values in recent years that resulted from the confluence of the lowest interest rates since the 1960s, aggressive mortgage lending, and high levels of speculative activity in the real estate market.

Indeed, the 2001–2005 period saw the most rapid rate of home price growth relative to CPI inflation in history, so a period of mean-reversion in the residential real estate is to be expected; the only uncertainty is over what period of time the adjustment occurs.