You can't solve a housing bubble with tight money, but you can cause a crisis

Here is a brief I wrote that Mercatus recently posted.  I don't think I've posted it here yet:

https://www.mercatus.org/publications/monetary-policy/danger-using-monetary-policy-address-housing-affordability

The gist:

But note that while the consumption of these newly wealthy real estate owners was inflationary, there is little that monetary policy could have done to change that. In other words, they were using newfound wealth to claim an additional 1.3 percent of GDP for their own consumption, according to Mian and Sufi. That claim on current consumption would remain whether the Fed produced 10 percent inflation or 2 percent deflation. In fact, as the United States discovered in the end, the only way for monetary policy to affect that claim on current consumption would be to allow disruptions in capital markets to become so severe that these rentiers would not be able to access their wealth. The future rental value of their homes has not changed. That future rental value is a product of high demand for living in cities with restricted supply of housing. Monetary policy can’t fix that. It didn’t fix it. Rents in the Closed Access cities are at least as high as anyone might have expected them to be in 2005. The only thing the housing bust accomplished was to prevent the value of those future rents from being fully capitalized into home prices after 2007.

If, before the housing bust became catastrophic, monetary policy within a functional range could not change the ability of these rentiers to claim more current production, then what economic adjustments must happen to satisfy their new consumption demands? If these rentiers were claiming 1.3 percent of additional GDP, where was it going to come from? If they were increasing their current consumption but not their current production, the gap must be met somewhere. Either other Americans would have to reduce their consumption by 1.3 percent of GDP, or an additional 1.3 percent of GDP would need to be imported, or some combination thereof. That had to happen regardless of the stance of the Fed.

Housing: Part 347 - Price/Rent Ratios over time

Here are some graphs of price/rent ratios, by zip code, for several metro areas.  (All x-axes have the same 2013 rental value, while the y-axes represent the estimated price/rent ratio for each year.)

The data is from the inestimable Zillow.com.  Price/rent ratios before 2010 are based on my estimates, using price and affordability data. (Except the first graph, where the x-axis is price, and it changes over time.)

This relates to one of the points I made in Shut Out, that the positive relationship between Price/Rent and a range of other measures (price, rent, income) means that you have to be careful attributing rising prices in low-tier zip codes to easy credit.  In the few metro areas where low tier prices did rise dramatically, I contend that this was really the result of high tier prices levelling off because there is a maximum price/rent level within each city.

Comparing LA and Seattle is useful here.  Low tier prices didn't rise at a different rate than high tier prices during the boom in Seattle.  But they did in LA.  Here, comparing LA to Seattle, we can see that the crescent shape of the Price/rent pattern was the same in both cities throughout boom and bust.  The difference is that homes across LA had gotten so expensive by 2006 - more than $400,000, even in the lowest quintile of zip codes - that by 2006, the P/R on low end homes was close to high tier P/Rs.  In 1998, Quintile 1 P/Rs in LA were about 7x (!), less than half Quintile 5.  In 2013 they were a little more than half, at 12.7x.  In 2006, they were within 17% of the peak P/R at 25x.

In Seattle, the peak P/R was 28x, not much lower than LA.  But, rents, and thus prices, are much lower in Seattle, so Quintile 1 P/Rs only went from about 70% to 75% of Quintile 5 P/Rs.  The ratio started much higher than LAs but didn't move much.  That is because prices in Seattle never went high enough for more than a small portion of the market to hit peak P/R levels.

Following are scatterplots of P/R against annual rent value.  In the updated 2019 numbers, P/R ratios across Seattle have moved higher than they are in LA for any given rental value.  But, since rents are lower in Seattle than they are in LA, the metropolitan median P/R ratio is still a little lower in Seattle.

Phoenix and Miami both seem to have seen some recovery at the low end.  They seem to contradict my claim that low end markets are underpriced.

Dallas and Atlanta are interesting.  Atlanta has partially recovered and Dallas has fully recovered to peak P/R levels, generally across the metro.  This also contradicts my claim that low end markets are underpriced.  I might have been able to say that in 2013 about both the cities and the low end within the cities.  But, not now.

This is a great example of how the premises determine the conclusion in a way that I am not sure can be resolved.  First, note that by this measure, in both Atlanta and Dallas, there was absolutely no sign of excess prices in 2006 and the collapse to 2013 was outrageous.  That would be the case even if you believe that home prices should not be sensitive to real long term interest rates.  Long term inflation protected treasury rates dropped from 4% in the late 1990s to about 2% in 2006 and are now near 1%.  Yet, in Dallas, at all three points, price/rent ratios were similar.

Now, if home prices aren't sensitive to rates, you might conclude that prices look reasonable in Dallas today.  But, you would also have to conclude that prices were reasonable in 2006 and that they were outrageously low in 2013.

On the other hand, you could argue that home prices should be somewhat sensitive to interest rates, and so prices in Dallas have been undervalued both during the bubble and after the bubble.  Or, taking all cities into account, it seems reasonable to conclude that home prices are sensitive to real long term interest rates, and where supply is elastic, supply increases rather than price.  Where supply is inelastic, price increases rather than supply.

If that is true, though, then cities with moderate or low price/rent ratios today should be building like crazy and rents should be declining.  Instead, building is tepid and rents are climbing.  I blame that on tight lending.  But, what if it's really because home prices really aren't sensitive to long term rates?  If that was true, then when rates are low, high land costs would cause building to be tepid and rents would rise.  Price/income would rise too.  That matches today's environment, but it doesn't match the boom period where low rates were associated with building and with moderating rents in the cities with elastic supply.

It seems to me that we have some sort of control over how sensitive home prices are to interest rates.  If they are not sensitive, it seems like an unstable equilibrium.  It is where we are now, with rising rents, rising price/income, but very low mortgage expenses for a leveraged buyer, compared to 1998 when mortgages cost 7%.

In the unstable environment, potential buyers are locked out because mortgage payments may take a large portion of their incomes.  But, in the meantime, so does rent.  And in that equilibrium, it will only get worse.  In the stable equilibrium, the important comparison would be real mortgage expenses vs. renting expenses, which would lead to a negative feedback loop where buyers could bring on new supply, and low rates would naturally help moderate housing costs.

More talkin'

I had a nice conversation with Josiah Neeley of the R Street Institute and Doug McCullough of the Lone Star Policy Institute on their podcast "Urbane Cowboys".




Elsewhere, Emily Hamilton, a research fellow at the Mercatus Center was on the Marketplace Morning Report, on NPR, discussing housing.  (Her segment starts at about 5:20.)  She was there, in part, to discuss a new brief co-authored by her, Salim Furth, and myself.


Also, some readers might be interested in this.  I don't work for this firm, Hoya Capital, but I found out that they just started a new housing ETF that is partially based on some of the same ideas you see here at IW.  The ETF is meant to give investors broad exposure to the housing market in general - including builders, REITS, lenders, etc. - so that investors can gain from a supply recovery in housing, however that recovery ends up being shaped.  That's my brief attempt at describing it, but certainly, if you are interested, you should peruse the details at the site.

Market Concentration

John Cochrane discusses an interesting paper that claims that, while national concentration has increased, local concentration has decreased.  In other words, each location has more competition within various industries, but the competition is more among national chains than among local firms.  So, there top firms claim a larger portion of the national market, but at the local level, consumers have more choices.

What's going on? The natural implication is that the town once had 3 local restaurants, two local banks, and 3 stores. Now it has a McDonalds, a Burger King, a Denny's and an Applebees; a branch of Chase, B of A, and Wells Fargo, and a Walmart, Target, Best Buy, and Costco. National brands replace local stores, increasing the number of local stores.

Writing and talking

Garrett Peterson kindly asked me back on the Economics Detective podcast.  It's always a pleasure to chat with Garrett.  The podcast is here:






And, here is an op-ed in the Los Angeles Daily News:

Claiming that building more L.A. housing would only benefit newcomers misses the point. The newcomers are coming already, and they aren’t waiting for L.A. to build them homes. Rest assured, until the rate of new building is increased, the homes that those newcomers will take will still be provided, quietly and sadly, one unit at a time.

Housing: Part 346 - Making the Crisis Inevitable

My new policy brief is up at Mercatus.  The important part:

This means that a collapse in prices was not inevitable. But more importantly, this means that calls for tighter monetary policy during the boom were calamitous. Loose monetary policy has been widely blamed for high home prices and for the debt-fueled consumption that they funded. Critics, and even Federal Reserve policymakers, generally agree that monetary policy should have been tightened sooner. But this is the wrong conclusion. In fact, monetary policy was powerless to counteract the debt-fueled consumption of the boom period, and the bust was only inevitable because the Fed tried to solve a problem that it could not functionally solve with tighter monetary policy.

and:

As in 2005, the primary stresses that characterize the American economy do not have a monetary source or solution, but mistaken monetary attempts at solutions are capable of adding to those stresses. Certainly, there is no reason to tighten policy today as a reaction to high home prices. 

Housing: Part 345 - Come on in. The water's fine.

Via Tyler Cowen:

Between 2003 and 2006, the Fed raised rates by 4.25%. This tightening induced a large contraction in deposits, leading banks to substantially reduce their portfolio mortgage lending. Yet, this contraction did not translate into a substantial reduction in total mortgage lending. Rather, an unprecedented expansion in private-label securitization (PLS), led by nonbank mortgage originators, substituted for most of the reduction in bank portfolio lending and thus largely undid the impact of Fed tightening on the mortgage lending boom.

Edit: it isn't so clear in my excerpt, but what is interesting in this paper is how they isolated the sensitivity of bank deposit rates to the fed target rate to show that banks systematically substituted securitized lending for portfolio lending. In other words, tightening monetary policy was a key factor leading to the growth of private securitizations. The Fed was tightening, in part, to slow down mortgage lending, but what they ended up doing was slowing down everything else.  I have a brief coming out soon explaining how it was unlikely to be any other way.

February 2019 CPI

Inflation took a step down this month.  There is little need to repeat my monthly mantra.  This takes us a step further to a situation where consumption may be waning, but the Fed thinks inflation is near their target because of high imputed rent inflation.  And, they think the risk is toward more inflation because of the low unemployment rate and Phillips Curve thinking.

Trailing 12 month core inflation is at 2.1%.  But, core-non-shelter inflation is down to 1.2%.  (Sorry, not shown.  I'll update when I can.)  TIPS forward inflation is also below 2%, although it has recovered from its recent lows, but that is also a bad sign, since that suggests expected non-shelter inflation is below 1% for the next 5 years, unless there is a building boom around the corner.

Housing: Part 344 - Square Footage over time

Here is an interesting piece on housing supply in England. (HT: TC)

There are two graphs in the piece, shown here.  And, the author, Ian Mulheirn, argues that data on home size shows that there isn't a supply shortage.

I have posted on a previous post of Mulheirn's where he makes a similar argument.  His previous post was somewhat persuasive to me, although astute readers pushed back in the comments on my post.  On this new post, I think Mulheirn might be betraying a bias toward his conclusion a little more clearly (at least for me to see).

The charts show that in England as a whole, floor space per person has increased by about 4% since 1996, although that all came in the late 1990s, from one data point.  For London, floor space has been level since 1996, and has declined since 2000.  He interprets this as evidence that there is not a supply constraint nationwide, and only a small constraint in London.

There is a similar story in Manhattan.  Population in Manhattan is about 25% lower than it was in 1910.  But, over that century, a lot of square footage has been added in Manhattan.  So, two things are going on at the same time.  We are getting richer, so we don't sleep 6 to a room in tenements anymore.  And, building hasn't been able to keep up with that change in standards.

So, benchmarking to an unchanging floor space size is not a neutral way to benchmark.  This is obvious looking at the very long term in Manhattan.  The irony is, units could have been added vertically to provide that extra space in Manhattan to maintain a stable population.  All that building wouldn't have added any new strains to the things like the city's transportation infrastructure.  One would hope that, over a century, the transportation infrastructure would have become more efficient so that the population could have even grown.

But, even over the shorter timeframe to the mid 1990s, one can imagine changes in norms, such as siblings being less likely to share bedrooms or households having fewer members, on average.  Since 1996, per capita real GDP in the UK is up 36%.  Now, I don't expect floor space to increase 1:1 with real incomes.  But, even there, some of the reasons we wouldn't expect floor space to increase would be because of local supply constraints that make it difficult and also because richer households might spend less of their incomes on shelter.  So, there is some combination of factors at work.  Either floor space should have increased by 36%, or there are supply constraints, or rents should have declined as a portion of household income.

Outside of London, according to Mulheirn's previous post, rents have declined as a portion of incomes, and here he shows that floor space is up slightly.  That does suggest that supply is not particularly constrained in those areas.  This could be because of looser building policies or because of less demand for living in those places.

In London, it appears that the 36% growth in real incomes has led to about 36% growth in rental costs for slightly smaller units.  That suggests that rent inflation is significantly higher than general inflation in London, which is similar to what is going on in American Closed Access cities.  That seems like the sign of a constrained asset class that collects economic rents for exclusive ownership rights.  I'm not sure that supports Mulheirn's position that there isn't a supply problem as much as he thinks it does.

February 2019 Yield Curve Update

Well, could the Fed end up with a soft landing here?  Interest rates have recovered somewhat.  We are basically at the same place we were a month ago, but it seems that sentiment has turned toward asking the Fed for more wage growth rather than worrying so much about inflation and asset prices.  And, the market seems to believe that the Fed is done hiking.  Forward inflation expectations are moving back up too.

In terms of my measure of inversion, it hasn't budged, and when inversion has happened in the past, it has always been uninverted by lowering short term rates, not by sitting tight while long term rates rise.  That doesn't mean it would be impossible.  My hunch is that we are still more likely to see an eventual contraction, where the Fed will hold to the current rate target for too long as conditions deteriorate.

It still seems like the best position is to be somewhat defensive - that the next big asset class move will be higher bond prices.

But, there does seem to be a change in the air.  Can positive sentiment be strong enough to push savers into risk-taking and push long term yields up while the Fed stays put?