Thursday, September 3, 2015

Housing Tax Policy, A Series: Part 58 - Housing and the CPI

Adam Ozimek has an interesting article on rent inflation, which Matthew Yglesias previously referenced and recently tweeted a reminder about.  He argues that rent tends to be a sticky price.  CPI measures of rent and imputed rent measure average rents, which are an accurate measure of experienced inflation.  But, Ozimek argues that market rents - rents being charged in newly established leases - will reflect current market dynamics more accurately and aid in more responsive monetary policy.  This is a good point.

Here is a graph from the paper comparing year over year changes to CPI owner-equivalent rent, market rent, and Case-Shiller home prices in the Washington, D.C. area:

The market rent measure tracks the change in home prices more closely, collapsing and recovering earlier than CPI O-E rent inflation did going into and coming out of the recession.

I have used core-minus-shelter inflation as a way to avoid the misleading signals that shelter inflation has been giving.  A big problem is that shelter inflation reflects a supply problem.  But, it does seem as though using market rents instead of total rents may at least eliminate the problem of cyclical signals, even if the secular supply problem remains.

It looks like market rents might have given an even earlier indicator of demand problems than my core-minus-shelter indicator, but this may partly reflect idiosyncratic movements in Washington, D.C. real estate.

Also, it is interesting that O-E rent inflation for Washington, D.C. shows the same bump up in 2006-2007 that the national indicator does, but the market rent measure does not have the same behavior.  I have been using that movement as a sign of a supply constraint in housing coming from the early collapse in residential construction.  This could be an idiosyncratic factor specific to Washington, D.C., too, but if it does reflect a national difference in the data, it would weaken my supply argument during that period.  On the other hand, it confirms the weakness of inflation measures throughout 2006 and 2007.

There is some disagreement about whether home prices should be used as a proxy for shelter cost of living adjustments instead of imputed rent.  I strongly disagree with that idea.  That would be like using the price of bonds to measure inflation.  But, I can see why it seems like it would be a better measure.  I think partly what is happening is that home values are marked to market.  There is some price stickiness in home prices, but there isn't the sort of stickiness that differentiates ongoing lease rents from new lease rents.  We measure home prices only by recent transactions, so measured home prices reflect market prices in a way that CPI rent measures do not.

(Whereas rents for tenants with some tenure tend to dip below market rents, homes would probably have the opposite effect.  Homeowners tend to give their homes higher values than the market value.  We see this in a comparison of Survey of Consumer Finances to Flow of Funds data.  But, most measures of home prices don't use survey data.)

In any case, while I think that home prices are not appropriate as an inflation indicator, that doesn't mean they don't make a good cyclical indicator.  Price/rent or price levels may be good cyclical indicators, but this is because they are signals of changes in expected real spending growth or mortgage market disequilibrium.  It appears that for measuring inflation, Ozimek's market rent inflation measure captures some of the timeliness that home prices carry, but without some of the baggage.

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