The Economic Double Standard: Can Inflation Occur with Housing Prices Falling?

It might seem like cognitive dissonance to think about inflation in the midst of falling housing prices.  The Consumer Price Index (CPI) tracked by the Bureau of Labor and Statistics shows that housing makes up 43 percent of the entire index.  Of this, 24 percent is made up of a category called owners’ equivalent rent of primary residences (OER).  This rather interesting category looks at the market value rent of your home if it were turned into a rental.  This category however under reported housing inflation on the way up in the bubble and now is under reporting the decline in home prices and also rents.  The housing market as we all know has taken a major hit in the last few years.  Given the large weight in the CPI, is it possible to have inflation with home prices falling?

In economically tough times, people begin to shift their spending habits to items of daily necessity.  It is hard to find examples of home prices falling while inflation picks up.  One clear example however is the Weimar Republic hyper-inflation period:

The above is a rather fascinating example of how households will shift budgets to daily necessities.  If we look at the 1912-13 period in Germany both rent and food took up about 30 percent of household expenses.  But that was the last time any balance like this was seen in over a decade.  Quickly, food started taking up a much higher percentage of the household balance sheet as people started shifting to more daily necessities.  After one decade, 91 percent of household expenses went to food while rent only made up 0.2 percent of expenses.  So if we are arguing the theoretical, it is possible to have housing prices collapse while inflation rages on like the hyper-inflation Germany faced.

Let us now shift gears and look at our current situation.  The housing market has been steadily falling since it hit its peak in 2005.  Even though it may look like prices have stabilized, rents in many parts of the country are still going lower.  Let us break out the components of the CPI for a better perspective:

Clearly housing is the biggest line item in the chart above.  Households spend 15.75 percent on food and 15.31 percent on transportation costs.  With oil falling as it did and the auto industry in turmoil, this component of the CPI has moderated in the last year.

If we look at the components in closer detail, we start seeing where the change is really occurring.  Let us look at the OER component:

OER has never gone negative year-over-year in record keeping history.  We would need to go back to the Great Depression to find another time that has occurred.  But we are a few months away from going negative for the first time as the chart above highlights.  The government has subsidized the housing market with low interest rates and tax credits and has shifted demand from the rental markets.  Ironically many commercial real estate developments are hurting even more because of this shift.  Those who would have rented are now pushed into buying homes.  So you can expect the OER to go lower.  Take for example high cost of living areas like Orange County and Los Angeles:

“(LA Times) Maguire Properties, then under the direction of founder Robert F. Maguire, acquired the Michelson Drive building in 2007 as part of a $3-billion purchase of 24 office buildings in Orange and Los Angeles counties. Borrowing money for the heavily leveraged purchase was fairly easy at the time with capital markets still flush with cash.

The bold move greatly expanded Maguire Properties’ presence in Orange County, but the obligations turned into a financial millstone. The hot Orange County market cooled dramatically, leaving Maguire and other landlords to struggle with high vacancy rates and falling rents.”

Commercial real estate and rental prices are falling across the country.  Let us look at another component of the CPI with food:

Food has actually fallen on a year-over-year basis.  But we are starting to see shifts in consumer behaviors as people start focusing on daily necessities.  36 million Americans are on food stamps so a large proportion of the population is allocating much more than 15 percent of their income to food.  With commodity prices already spiking, it will be important to keep an eye on this important measure.  Even though prices are down year-over-year, prices have been spiking since September of 2008:

So is it possible to have inflation while home prices fall?  The way the CPI is currently set up 43 percent of the index is composed of housing so it will be tough.  However, like the stock market rally of 60 percent it is not reflecting the 10.2 unemployment and the 27 million Americans who are out of work or underemployed, the CPI doesn’t necessarily reflect the reality of many Americans.  With rents falling and food prices likely to go up, many Americans are going to spend a larger percentage of their take home pay on food.  If that is the case, the index needs to adjust to reflect this reality.

Take for example someone that used to pay $1,500 on their mortgage and $500 in food a month.  Say this family is one of the millions who lost their home and is now renting an apartment for $750.  Their housing expense has fallen in half but it is very likely they are still spending close to $500 on food.

As usual, it is important to dissect the data before rushing to judgment.  It is possible to have inflation while home prices fall but it is likely to be hidden in the way the CPI is constructed.

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