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Housing Disinflation Isn’t Happening Yet

Before everyone gets too animated about the decline in core inflation, with calls for central banks to put the brakes on rate normalization, let’s realize that the main drivers of lower inflation over the last few months – zero rise in core CPI over three months! – are not sustainable. I’ve written previously about the telecommunications-inflation glitch that is a one-off effect. Wireless telephone services fell -1.38% month-over-month in February (not seasonally adjusted), -6.94% in March, and -1.73% in April. In May, the decline was -0.06%. Here is a chart, courtesy of Bloomberg, showing the year-to-date percentage declines for the last decade. The three lines at top show the high, average, and low change over the prior decade, so you can see the general deflationary trend in wireless telecom services and the historical outliers in both directions. The orange line is the year-to-date percentage change. Again, the point here is that we cannot expect this component of inflation to deliver a similar drag in the future.

The other main drag comes from a less-dramatic decline in a much-larger component: Owners’ Equivalent Rent. In this month’s CPI tweetstorm, I pointed out that this decline is mostly just returning the OER trend to something closer to our model (see chart below), but many observers (who don’t have such a model) have seen this as a precursor to a more-significant decline in rents.

This is actually a much more-important question than the dramatic, and easy-to-diagnose, issue of wireless telecommunications, because OER is a ponderous category. You can’t get high inflation without OER rising, and you can’t get deflation or even significant disinflation without OER declining. It’s just too big. So what are the prospects for OER rolling over?

Here are two reasons that I think it’s very unlikely that this is a precursor to a significant decline in housing inflation.

First, while I understand that rent increases in some parts of the country are moderating, they are always moderating somewhere in the country. Owners’ Equivalent Rent tends to parallel primary rents (“Rent of Primary Residence,” which measures the actual price of a rental unit as opposed to implied rent of an owner-occupied dwelling) reasonably well, and when home prices are rising it tends to imply that rents – as the price of a substitute, at least for the consumption part of home prices – are also rising. (A house is both an investment asset and a consumption good, and the BLS’s method for separating these two components of a home recognizes that the consumption component should look a lot like the substitute). And the fact is that Primary Rents are not (yet?) decelerating much (see chart, source Bloomberg).

Yes, I understand and agree that home prices are already too high to be sustainable in the long run. Either incomes need to outpace home prices for a while, or home prices need to decline again, or we need to become accustomed to housing becoming a permanently larger part of our consumption and asset mix (see chart, source Enduring Investments).

But is that going to happen? Well, here are two charts that should make you somewhat skeptical that at least on the supply side we are about to see a decline in home prices. First, here is the index of Housing Starts, which last month took a nasty drop. Even without the nasty drop, though, notice that the level of starts was not only far below the level of the last few peaks in the housing market, but actually not far above the troughs reached in the recessions of the mid-1970s, early 1980s, and early 1990s. The only reason the current level of starts looks high is because homebuilders basically stopped building for a few years after the housing bubble.

Homebuilders stopped building because there was suddenly plenty of inventory on the market! In the immediate aftermath of the bubble, the homes that were available for sale were often distressed sellers and as prices rose, more and more of the so-called “shadow inventory” (people who wanted to sell, but were now underwater and couldn’t sell) was freed. This kept a lid on overall housing starts, but the net effect is that even now, when most of that shadow inventory has presumably been liquidated (a decade after the bubble and at new price highs), the inventory of existing homes available for sale has become and has remained quite low (see chart, source Bloomberg).

The supply side, then, doesn’t seem to offer much cause to expect home prices to moderate, even if their prices are relatively high. I’d want to see an overreaction of builders, adding to supply, before I’d worry too much about another bust, and we haven’t seen that yet. So we have to turn to the demand side if we expect home prices to decline. On that side of the coin, there are two arguments I sometimes hear: 1) household formation in the era of the Millennial is low, or 2) households don’t buy as much housing as they used to.

There is no evidence that household formation has slowed in recent years. As the chart below (source Bloomberg) shows, household formation has been rising since 2009 or so, and is back in line with long-term trends. Millennials may have weird notions of home life (I don’t judge!), but they still form households of their own.

As for the second point there…notice that I phrased the question as whether Millennials are buying less housing, rather than as buying fewer homes. I think it’s plausible to suggest that Millennials might demand fewer homes to buy, but it’s hard to imagine that they’re neither going to rent nor buy homes – and if they do either, they are demanding shelter as a consumption item. It just becomes a question of whether they’re demanding rental housing or owned housing.

The upshot of this is that there’s no sign yet of a true ebbing in housing/rental inflation. And until there is, there’s scant need to fear a disinflationary trend taking hold.

  1. June 19, 2017 at 4:18 pm

    The median home price to median income chart would look a lot more normal if it is flipped (income/home price) and compared to the secular decline in interest rates. A house is a fixed income investment paying real shelter coupons daily.Compared to market real yields houses are still cheap.

    • June 20, 2017 at 6:40 am

      This is an excellent point, but I am obliged to pony on two additional points. The first is that this wouldn’t explain why the relationship was so quiescent and regular prior to the housing bubble. The second, and more important I think, is that this is akin to the argument for why stocks are where they are: it explains high stock prices, but it doesn’t justify high stock prices unless interest rates are permanently lower. Having said that, it is a keen insight to look at the home as a real shelter-coupon paying bond. Thanks for that great point!

      • June 20, 2017 at 8:24 am

        The relationship was regular prior to the bubble because the secular decline in real rates took place after the bubble. Long-term real rates weren’t really observable prior to the TIPS start in 1996, and even if they were a part of the real rate volatility was risk premium finding equilibrium after the 70s-80s swings.

        The permanence of low interest rates currently is debatable (I’d take the side of permanence, since demographics won’t change much) but the rates are what they are. It’s a bigger question than housing, with the range of end-games similar to the final lives of stars (from black hole to neutron star to supernova).

    June 19, 2017 at 4:22 pm

    There is no shortage of inflation in property taxes…

  3. Eric
    June 19, 2017 at 5:05 pm

    I’m not sure how to factor this in, because i don’t know exactly what housing starts counts and doesn’t, but I can tell you this: Tampa/St Pete, etc look exactly like 2006 with one difference that you can’t even see: instead of buiding luxury condo towers, they are building huge luxury apartment buidlings that are for rent.

    I do think millennials want significantly *less housing*. But more importantly, they want to rent it, and they want to rent it in big buildings. I’m not sure what that does to housing starts, but it seems plausible that one could service millennials demands for shelter with many fewer housing starts.

    • June 20, 2017 at 6:43 am

      I agree, and I think that’s true – with lower millennial demand (and, though I forgot to put this in, negative demand from downsizing boomers) it is plausible that the physical housing market could clear with a much lower level of new inventory. Although the low homes-available-for-sale don’t necessarily say the market is balanced; it still looks short. But further, my point about needing a roof for every household combined with your thought that Millennials may rent in greater numbers just means the upward pressure in rents will be higher than the upward pressure in OER until rental properties are overbuilt. Yeah, there’s clearly a lot of dynamics in this relationship.

  4. June 20, 2017 at 8:40 am

    The high percentage of home ownership always seemed to be like a market failure. Professionally managed rentals seem like a much more efficient market solution. If the same share of personal wealth is desired in housing buying shares in REITS etc gives both more flexibility and diversification. Of course some failures are real (both agency problems and government interference are pretty severe in housing)

    • Eric
      June 21, 2017 at 7:56 pm

      Rents are putting upward pressure on prices in tampa. Lots of houses and condos are selling for cash to investors who are looking for yield. So the effect is already in play and already arbing out.

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