Friday, September 4, 2015

Housing Tax Policy, A Series: Part 59 - The Effect of the Housing "Bubble" on Nominal Incomes

Yesterday's post was about the effect of rent measurement on inflation.  One common refrain about the 2003-2005 expansion period is that inflation and GDP measures for the period don't capture the extent of the monetary over-heating of the period.  Today, I thought I would look at those measures and see how they would look if we accept the basic premise of this view.

Gross Domestic Income with a Real Estate Capital Gain Adjustment

First, regarding GDP, the measure I will use is GDI, which tends to follow GDP very closely.  In a recent post, I referenced some research that calls to doubt whether any significant amount of new spending correlated with higher asset prices is related to a wealth effect, but some research suggests an increase of a few dollars per year for each $100 in asset gains.

I am using the quarterly change in the market value of real estate held by households, from the Federal Reserve's Z.1 Financial Accounts data, multiplied by 4 to estimate a seasonally adjusted annual rate of growth, minus fixed private investment in structures (since this would have increased the value of real estate in a way that is already reflected in GDI).  I am using, not just the gain in equity, but the entire gain in market value, so that I am capturing the possible effect of equity gains and credit expansion (the housing ATM).  For our exercise here, I am going to simply count half of the gains and losses in real estate as an adjustment to income.

Here's the graph of this measure, compared to unadjusted GDI:

Here are graphs of GDI and the adjusted GDI levels, in both log scale and linear scale, to get a feeling for deviations from short and long term trends.

There is a bump up in income in the late 1990s and then again in the 2003-2005 period that is larger than this adjustment had been in the past.  Generally what we see here is that nominal income growth was more moderate in the 1990s than it had been before 1980.  Even with the adjustment, nominal income in the 2003-2005 period is roughly similar to expansion periods before 1970 and is still much lower than the expansionary peaks of the 1970s.

As with so many of these measures, in hindsight, the bust was much more of a disruption than the boom.  So, if we are going to look at home prices as factor in nominal income, and give some weight to household capital gains and losses, then 2006 looks much more unusual than 2003-2005.  In fact, this isn't a terrible adjustment to make, in some ways.  It might even be helpful.  But, if we were to use this adjustment to GDI as a cyclical indicator, the most significant change this would have caused in our real-time reaction to cyclical fluctuations would have been to call for massive monetary accommodation by early 2006, because GDI adjusted for real estate capital gains was signaling the worst nominal downturn since at least 1950.

Inflation Based on Home Prices

To look at inflation, I have three series for comparison.  One is core CPI inflation with no shelter component, one is the standard core CPI inflation with rent, and the other is core CPI inflation with the change in home prices substituted for the change in rents (using the Case-Shiller national index).

Here, if we use home prices to create the core CPI, inflation levels in the 2000s tended to run about 4% - roughly between the levels of the late 1980s and the 1990s, but lower than the 1970s.  This measure of inflation rises to about 6% in 2005, though, of course, during 2005 the Fed Funds rate was rising from 2% to 4%, on it's way to the high of 5.25% in early 2006.

This indicator shows a collapse by mid-2007, similarly to the Core-minus-Shelter inflation measure.  So the timing is about the same.  But, the scale is much sharper, and the deflationary signal of this measure remains until 2012.

As with the GDI adjustment, there is some indication here of inflation on the high side of normal ranges during the expansion, but the signal of a deflationary shock that this adjustment gives comes earlier than traditional measures do, and is stronger to the downside than the expansionary excesses were to the upside.

Anyone using this adjustment in 2003 or 2004 to argue for monetary tightening must have been going mad in 2007, begging for monetary accommodation.  Really, from 2007 through 2011, someone using home prices would have labeled monetary policy as deflationary.

Ironically, it appears to me that using these adjustments can be useful.  I think monetary policy would have been more stabilizing and timely if these indicators had been given more attention.  Yet, where they were most useful were as early indicators of the economic crisis, and I don't think I know of anyone who mentions these indicators as signs of monetary excess in the 2000s who also uses them as signs of monetary deprivation after 2006.  This is the period where they give the sharpest signal, and I hope we can agree in hindsight, they gave signals that we would have benefited from acting on.


  1. TravisV here.

    The latest Barron's has a very interesting article: "As Stocks Fall, Real Estate May Be the Best Defense"

    A sample: "Overall there just isn’t much correlation of home prices with the stock market. So [what happened in 2007-2009] looks like just chance.”

    Kevin, have you written any posts that pertain to this topic? Thanks.

    1. I don't think I have, directly. I think since 2006, there has been a disequilibrium. Before that housing was generally in equilibrium, so it might have shared some of the decline in expected income growth on the downside with equities, but it would gain from the associated fall in real long term interest rates that would tend to come along with that, so future rents might be lower, but their present value would be the same.

      I haven't looked into it as much as I'd like, but I suspect the REITs don't share this behavior because they tend to use leverage to boost average returns, but that leverage gives them a net short position on bonds, which counteracts the natural bond-like behavior of the equity position in the house.

      Houses are still out of equilibrium, so I am not confident about how they would react to a new bear market, although I assume the relatively low level of price/rent and the very low level of young mortgages with low loan-to-value levels will buffer any downside influence.

      I originally thought that home ownership had brought excess returns to the marginal owner because of limits to credit access, and that the reduction of those limits in the 2000s (because of low nominal interest rates and modern financial instruments) allowed marginal households to bid away those excess returns, pushing up the prices of houses. But, I am coming around to the idea that there wasn't much excess return for housing before, and that rising rents (and expected rents) explain just about all of the unusual price increases in the 2000s, and only since the collapse of federal monetary and fiscal support for traditional housing finance after 2005 have we entered a context where there are excess returns to home ownership because of a lack of access.

      In that context, if you have access to capital and can deploy it in housing, then you'll eventually have risk adjusted excess gains. Even those REITs should do well if they aren't trading well above book value, because the returns on their assets should be higher than the risk-adjusted cost of their debt.

    2. Oops, 3rd paragraph should say "young mortgages with high loan-to-value..."