Housing: Part 259 - Phoenix home prices and interest rates

As readers who have watched my time-lapse chart of home price changes know, the price movements in bubble cities like Phoenix were peculiar, and they happened late in the process.  Late enough, in fact, that Phoenix prices still looked very normal, even as the Fed started to raise rates in 2004, and it was only after rates started to rise that home prices in Phoenix shot up.  That is because the bubble in Phoenix had little to do with monetary policy and much to do with a massive Closed Access refugee crisis that brought tens of thousands of migrants to Phoenix - some needing rental housing and some with sweet Closed Access capital gains cash burning a hole in their pockets.  These are the ingredients of a bubble.  And a classic bubble is basically what Phoenix had.  It just didn't have much to do with interest rates.

Of course there are many people who blame the housing bubble, in general, on loose monetary policy - the Fed held rates too low for too long and that caused buyers to borrow too much and to bid up the price of homes to unsustainable levels.  I have concluded that this is not correct.

But, all of that aside, and the "cause" of debating the truth of the matter, learning better policy prescriptions aside, given how widely that belief is held, these graphs are just funny.  If any Fred graph could make you laugh out loud, these have to be them.  The first graph is the price level in Phoenix compared to the Fed Funds rate.  The second graph is the one year change in the price level in Phoenix compared to the one year change in the Fed Funds rate.



Source

Come, on.  That's funny.

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So, I noticed over at Bob Murphy's blog in the comments of a post, there was some chatter among the Austrian Business Cycle folks about how low interest rates caused the housing bubble.  So I posted links to these graphs and asked for replies.  Nobody is going to change a deeply held belief over a couple of Fred graphs, so I thought it would be interesting to see what explanations they would come up with to explain how home prices accelerated as interest rates increased.  I was sure they would have some.

Bob even kindly copied the graphs into a new post for his readers.  There wasn't much reaction to it.  I really didn't even get to see many explanations.  I think I am accurately portraying the reaction by saying Bob and his readers didn't feel like this needed an explanation because these graphs are self-evident confirmations of the Austrian theory that low interest rates cause asset price bubbles.

Bob thought this third graph was the best way to look at it - with the Fed Funds level and the change in prices.  When prices were accelerating in 2005, rates were rising, but they were still relatively low compared to previous cycles, so they were still capable of fueling the bubble.

In the current version of the manuscript I am finishing, I sometimes try to get the reader to mentally commit to a stated expectation before I review the actual data. I wonder if I should even place empty graphs in the book and say, before you read the next chapter, draw a graph of what you think, say, homeownership rates did over this time period.  I think if I asked a room full of 100 Austrian BC proponents to draw a graph of home prices and interest rates, none of them would draw anything like this.  The blue hump would be one or two years earlier, at least.  None would have prices decelerating in 2002 and 2003.  But, upon seeing the actual graphs, fully 100 of them would agree that they had all miscalculated and placed the price run up too early.

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In fact, the graph they would draw would probably look much like the graph of Los Angeles home prices.  That's because Los Angeles housing wasn't whip-sawed by a migration shock.  Los Angeles was the source of the shock, because the same rising rents that were the fundamental cause of the rising prices were also driving residents out of town.  And, yes, low (long term real) interest rates and flexible financing made those prices rise higher.

Whatever else you might say about it, though, the Los Angeles graph isn't very funny.

A List of Presentation Topics: Give your audience a new view.

The work I have been doing over the past two years has led me to many surprising conclusions about the economy and financial markets.  I have developed an incredible amount of material that will be thought provoking for many types of audiences.

I will be making a number of public appearances and presentations in 2018.  I expect to publish two books on the topics of the urban housing problem and the financial crisis early next year.  In the meantime, I can present this work to your firm, your trade group, your conference, etc.

If you have been following this blog, you know that the content here will contain new empirical evidence and concepts that your audience will either find surprising, dubious, or maybe even infuriating.  They will definitely leave with new food for thought.  I say that with confidence because I have had those reactions myself as I have discovered this story and its many facets.  Readers here also know what I'm talking about.  We have discovered these surprises together.

If you need a speaker please contact me via the email address in the right hand margin ( idiosyncraticwhisk@gmail.com ).  If you know of someone who might be interested, please pass this post on to them.  This is a chance to give your group an early peek at the emerging understanding of the housing bubble and the financial crisis.

Because this project has developed such a broad reach, I can easily focus the topic on any number of specific ideas, depending on the interests of your audience.  Following is a list of some of those topics.


Various Audiences
A new retelling of the housing bubble and the financial crisis.  The motion graph here summarizes the story.

• The bubble didn't make the US different.  The bust did.
• The "Housing Bubble" Scariest Chart in the World should be disaggregated.  The housing bubble is a metro area phenomenon, not a national phenomenon.
• The subprime bubble, and the CDO bubble were not associated with new homeownership.
• Migration was a key factor in the housing bubble.  There are two distinct kinds of bubble cities.
• The bust didn't undo a bubble.  There was a supply bust and we added a demand bust to it.
• Mortgage defaults, and ultimately defaults of CDO securities, were largely the result of late decisions in credit regulation and monetary policy that undermined low tier housing markets in 2009 and after.

Financial Advisors & Real Estate Investors
There was never an overinvestment in housing or an inevitable supply overhang.  Understanding this provides insight into real estate investment potential.

Since 2007, there has been an extreme bifurcation of yields between real estate and fixed income asset classes.  This has implications for investors.

Since 2007, the US economy has experienced a regime shift in access to capital.  For those with access, this can lead to high returns.

Low tier real estate markets have experienced two distinct valuation shocks over the past twenty years.  Together, those shocks make low tier markets appear to be more volatile, but the shocks were unrelated to one another.  Going forward, these markets are likely to be less volatile.

Understanding the effect of housing on inflation can provide insights on Fed policy biases and the business cycle.

Rent is how we consume housing.  Homeowners are both tenants and landlords.  When housing markets were stable, we could get by with unchanging, simple heuristics about price, rent, and ownership.  But, supply constraints, volatile prices, and regime shifts in credit access require a more detailed approach.  Understanding these shifts can help families to make better decisions about ownership and consumption.

An upside-down CAPM.  Thinking of risk free interest rates as a discount subtracted from at-risk yields instead of thinking of at-risk yields as a premium added to risk free rates can yield subtle new understanding about the business cycle, investment returns, and leverage.



Public Policy
The high level of household debt is not funding consumption.  It is funding the obstruction of production.  Urban density is the gateway to equitable post-industrial abundance.

The mortgage crackdown has been a crackdown on young families and middle class homeowners.

A review of limited access governance and euvoluntary exchange.  If your "affordable housing" policy means that developers have to build "below market rate" units so that they can also build units whose prices are well above the cost of construction, then your city has actually implemented a peculiar and specific long term commitment to unaffordable housing.

The "China problem", secular stagnation, and labor immobility problems are actually housing shortage problems.  An unsustainable housing bubble didn't temporarily mask these problems.  Housing expansion was the sustainable solution to these problems.

Access is key.  The financial crisis was the result of a rejection of access, not a surplus of it.

The urban housing shortage leads to demands for ruinously tight monetary policy.  The housing shortage leads to zero-sum political battles.

Loose monetary policy didn't cause a housing bubble.  Monetary policy has ranged from neutral to tight for 30 years, and the housing shortage has a lot to do with that.

The GSE's mortgage guarantee, properly understood, is a monetary function.

Stability inevitably rewards the profligate and reckless.  Support stability anyway!  Raising risk spreads on purpose is the broken window fallacy applied to money.

The Housing Inventory Mystery

In real estate, and finance in general, I see a lot of standard analysis that seems backwards.  A lot of it would be something Scott Sumner would call "reasoning from a price change".  Analysis along the lines of predicting a decline in sales because prices have risen, making homes less affordable.  Prices are a signal of demand, not a cause of it.

This appears to be the case with inventory levels.  Inventory of homes for sale has been low during the recovery from the financial crisis.  Real estate analysts seem to commonly treat inventory as a signal of price shifts.  If inventory is low, that will lead to rising prices, because buyers have less supply to bid on.  If inventory is high, that will lead to declining prices.

This sort of analysis makes sense if we are looking at cyclical signals of a market with stable fundamentals that is constantly in a moderating process of finding an equilibrium of buyers and sellers.  In that context, rising inventory might signal an unexpected decline in demand, which would tend to lead to dropping prices.  That surely is what happened in 2006 and after.

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We can see that the first measure to peak was homes sold but not yet started.  Homes sold but not started is almost a sort of negative inventory, and it had been high during the boom.  After that began to decline, builders soon responded by reducing the number of spec homes they were building.  Demand was falling fast enough that spec homes finished but not sold rose until the beginning of 2008.  Considering that new home sales continued to decline to very low levels until 2011, this seems like pretty responsive inventory control to me.  The inventory of spec homes declined pretty sharply in 2008, even as sales continued to crater.  Inventory of existing homes (not shown), on the other hand, did remain elevated until 2011.

Since then, inventory has moved back down to the low levels previously seen during the boom.  If inventory is a leading indicator of seller power, then this is a bit of a mystery.  Low inventory should trigger rising prices and new home building.  But, home price appreciation has been moderate, even with strong rent inflation, and new supply continues to only develop slowly.

The reason is that the housing market isn't in the midst of normal cyclical shifts.  It is in the midst of a wholesale secular shift in mortgage access.  A significant portion of the population that once could count on having ownership as an option, cannot anymore.  Some families have negative or minimal home equity, which makes selling or moving difficult.  Some families wouldn't be able to qualify for a mortgage for the homes they already own.  There has been a large shift from ownership to renting, because of this.  That shift, itself, probably tends to tamp down low-tier and mid-tier housing demand, because there isn't as much value in renting vs. owning, due to the lack of control over the asset, and it also means that a significant conduit of new supply - sales to new homeowners - has been cut off, forcing other buyers of new units (new supply) to make up the difference.

The reason inventory is low is because there aren't many potential buyers, and families that do need to engage in real estate transactions might have to downsize or shift to renting if they can't manage to get funding.

So, as with interest rates, the signal here is probably flipped from the way it is normally thought of.  If interest rates rise, that will be a sign of expanding investment, which would likely be related to an increase in households able or willing to take an equity position in new homes.  Rising interest rates will probably be related to rising home prices and rising housing starts, even though that might seem counterintuitive.  (Actually, regarding interest rates, I'm not sure that this is that unusual.  On a secular time scale, long term real interest rates reflect broad trends regarding saving/consuming, etc., and do seem to have an inverse effect on home values.  But cyclical shifts in interest rates, especially short term rates, are more a reflection of short term shifts in demand and sentiment, so that housing activity tends to be strong when rates are rising during an expansionary period.)

Likewise, rising inventory will probably only come about when there is a new shift to more potential homebuying from those marginal buyers.  Rising interest rates, rising inventoary, rising prices, and rising starts will probably all either develop in unison, or not at all.

Reflecting on monetary policy, if the Fed was actually following natural rates higher, we would be seeing these developments.  Instead, the yield curve is flattening, credit growth is moderating, housing starts remain low, and non-rent inflation is dropping.  I suspect that the natural rate will remain very low either until we allow mortgage markets to adjust to their previous standards, or until the housing market fully adjusts to the new standard, where middle class households are generally renters and are consuming housing, in terms of rent, based on those new stable standards, instead of being grandfathered into the homes they were able to buy before the shift.

I think the barriers to supply in the Closed Access cities, which is an international problem, also lower rates by reducing potential investment, but comparing long term real rates since the crisis to before the crisis, the mortgage collapse seems like it could be a larger factor.

There are obviously many international factors that play into interest rates.  But, these real estate distortions are huge.  The Closed Access problem probably inflates real estate values in the US by $3 trillion or more.  Internationally, this must amount to something like $10 trillion of capital value that required no investment.  Up to 2007, this meant that Closed Access real estate owners earned excess profits for preventing new homes from being built.  When they sold those properties and realized those unearned gains, the new buyers had to transfer cash to those owners, using labor income to fund transfers to capital.  This led to rising mortgages outstanding from the buyers, but it also led to rising savings on the part of the sellers as they re-invested their realized capital gains (although these gains are not generally included in official measures of savings).

Since 2007, federal regulators have prevented new homes from being built through mortgage constraints.  This has caused profits on existing homes to rise, but kept home prices low.  So, the effect on mortgages is the opposite - mortgages outstanding declined instead of increasing.  But, otherwise, this is similar - capital captures high rental income, but this income cannot be easily reinvested into real estate markets, so there is an obstacle to the investment outlet that would utilize savings in a way that lowered capital incomes and lowered yields in real estate.  Savings must be invested in bond markets or equities.  So, yields in real estate are above long term ranges and yields in bonds are below long term ranges.  This also probably amounts to more than $3 trillion in distortions.  Here, it isn't an inflation of savings; it is a decrease in potential investment.  $3 trillion worth of homes have not been built, in spite of being economically useful, since the crisis.

All told, there are more than $10 trillion of distortions in the global real estate market either inflating the value of prior savings or decreasing available investments.  And, we should keep in mind that, in terms of yield, these distortions are somewhat targeted.  Yields aren't low in real estate earnings.  Total expected returns to equities are not particularly different than they normally are (somewhere around 7%, in real terms, in the aggregate).  These distortions get focused onto fixed income markets that don't have obstructions.  Developed market debt markets amount to about $90 trillion.  Some of that is not investment grade.  It seems reasonable that these distortions could affect yields in low risk markets.

Given this, complaints about foreign real estate buyers seem misguided.  First, if you impose a strict set of policies limiting borrowing among domestic buyers, of course there will be an uptick in buying from foreigners with access to foreign capital outside those controls.  But, secondly, that capital inflow might actually lead to some new supply.  It can't lead to much supply in the Closed Access cities, which is where the complaints are usually lodged.  But, it might lead to supply elsewhere.

Fed Policy Updates

I happened upon this great line from George Selgin:

In recent Congressional testimony,I likened the Fed's gain in flexibility in a floor system* — its being able to set its policy rate however it likes, while altering the supply of bank reserves however it likes — to the gain an automobile owner might secure, in being able to turn the wheel as much as she likes, while also stepping on the gas pedal however much she likes, by shifting from Drive to Neutral. The problem, of course, is that, while the driver seems to have more options, the car no longer gets her where she wants to go.

This reminds me of two extraordinary paragraphs from Bernanke's "The Courage to Act" (pg. 325-326):

(I)n 2008, we needed the authority to solve an increasingly serious problem: the risk that our emergency lending, which had the side effect of increasing bank reserves, would lead short-term interest rates to fall below our federal funds target and thereby cause us to lose control of monetary policy. When banks have lots of reserves, they have less need to borrow from each other, which pushes down the interest rate on that borrowing—the federal funds rate.
Until this point we had been selling Treasury securities we owned to offset the effect of our lending on reserves (the process called sterilization). But as our lending increased, that stopgap response would at some point no longer be possible because we would run out of Treasuries to sell. At that point, without legislative action, we would be forced to either limit the size of our interventions, which could lead to further loss of confidence in the financial system, or lose the ability to control the federal funds rate, the main instrument of monetary policy. The ability to pay interest on reserves (an authority that other major central banks already had), would help solve this problem. Banks would have no incentive to lend to each other at an interest rate much below the rate they could earn, risk-free, on their reserves at the Fed. So, by setting the interest rate we paid on reserves high enough, we could prevent the federal funds rate from falling too low, no matter how much lending we did.

Instead of lowering its target rate from 2% so it wouldn't run out of assets in the process of trying to suck cash out of the economy, the Fed found a new way to suck cash out of the economy to keep its target rate at 2%.  Three months of chaos ensued, and at the end of those three months, the target rate was lowered to near zero anyway.

During TARP, AIG, and all the rest of the chaos in September 2008, the Fed Funds Rate sat at 2%.  It has confounded me that every headline during that time didn't read, "Wait, why aren't they just lowering the rate?"  But, it's worse than that.  Part of the TARP legislation was the interest on reserves policy, implemented specifically to find a way to maintain a 2% policy without selling off every last liquid security the Fed had, which is what they would have had to do.

All of the drama of September 2008.  All the emergency programs, rule bending, arm twisting, etc. - it was all done so that the Fed didn't have to lower the Fed Funds Rate to a rate which it ended up targeting 3 months later anyway.  It's astounding that the Fed barely gets any criticism for that.  In fact, they would have received much more criticism if they had actually lowered rates and avoided all that drama.  As it was they were already being criticized sharply for trying to salvage the mess that arose.

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In current news, this was today's press release from the FOMC:

Higher prices for gasoline and some other items in the aftermath of the hurricanes will likely boost inflation temporarily; apart from that effect, inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee's 2 percent objective over the medium term. Near-term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely.In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 1 to 1-1/4 percent. The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation.

They are "monitoring inflation developments closely". Now, there is no chance that they will lower rates because of low inflation over the next few months, so this statement is actually a statement of bias.  What this statement actually means is that they will raise rates at the slightest hint of an excuse.  They have an itchy trigger finger.

Likewise, the hurricane comments sound reasonable, but in practice what this means is that we are likely to get some positive noise in inflation.  I suspect that at some point, there will be a measured statement that basically says, "while the recent slight rise in inflation is partially due to recent hurricanes, we believe this is also a sign that inflation is beginning to rise back to our 2% target."  And rates will be hiked.

Today, the FOMC updated its forecasts, which included reducing their forward inflation forecasts.  Upon the news, the odds of a December rate hike shot up.  Now they are at about 70%.  Their 2017 core PCE inflation forecast is 1.5% - down from 1.7% in June.  (Keep in mind, even the FOMC expects some extra inflation from weather events, so this decline is after taking that into account.)  Core PCE inflation over the first 7 months of the year has amounted to about 1.3%, annualized.

I don't really blame the Fed.  They would face opposition if they did anything else.  From what I see in the financial sector, sentiment seems to strongly favor rate hikes.  If financial analysts come to that conclusion, there is no reason to expect other people to object.

Coincidentally, Hurricane Katrina hit in August 2005, in the middle of the Fed's rate hikes at that time.  Inflation spiked in September 2005.  By the end of the year, the yield curve had completely flattened.  Because of the asymmetrical potential value embedded in long term rates near the zero lower bound, the yield curve will probably still have a positive slope when we enter a contractionary context at this level.  I'm not sure we aren't close to that now, with 10 year treasuries at about 2-1/4%.




* Referring to the large balance sheet and paying interest on reserves

Hours Worked and Real GDP Growth

Over the long term, growth in real GDP correlates, naturally, with growth in hours worked.  Here, I have graphed the 10 year change in total nonfarm business sector hours worked (relative to population growth) and the 10 year change in real GDP.

There has recently been a decline in hours worked, which is partly demographic (aging baby boomers) and partly economic (the Great Recession).

There seems to be a long-term decline in RGDP growth of about 0.3% per decade.  Regressing real GDP against time and relative hours worked, we get the residual shown in the graph.  The regression suggests that for each additional percentage gain in hours worked, real GDP growth increases by about 0.68%.  I am using rolling 10-year growth rates.

By this estimate, growth in the 1990s was largely related to rising work hours.  Then, in the 2000s, work hour growth declined, but GDP growth continued to be normal.  Then, with the Great Recession, hours worked and GDP growth fell.  Now, growth in hours worked is low.  But, real GDP growth is low, even adjusted for slow work growth.  I suppose that could still be demographic, since older workers are exiting the labor force, and younger workers are entering.  It probably isn't a coincidence that the GDP growth residual declined as baby boomers were entering the labor force, rose for 30 years as they aged, and then started to decline as they began to leave the labor force, although clearly the sharp trend shift is related to the Great Recession.

tl;dr: There was a sharp drop in total hours worked beginning in about 2000.  This would be enough to drop real GDP growth rates significantly, and it probably did.  But, real GDP growth has been even lower than this sharp drop in hours worked would suggest.

PS: Broken record alert: For the past decade, residential investment as a percentage of GDP has been about 1% below long term averages and construction employment as a percentage of total employment has been about 1% below long term averages.  Add 10% to the 10 year measure for both hours worked and real GDP and your within range of normal.  It's about housing..... One might argue that there is competition for scarce resources and you can't just add real GDP growth without accounting for pulling those resources away from other uses.  But, I believe there has been a decade long search for the answer to the mystery of idle labor, long-duration unemployment, and a glut of savings that happens to coincide with this shift.  If ever there was little tradeoff for marginal investment, it has been now.

August 2017 CPI

This month, trailing 12 month inflation remained at about 1.7%.  Core inflation less shelter remained low: 0.1% for the month and 0.5% for the year.  Rent inflation this month spiked, which is mainly what is keeping core inflation above 1%.

On the news, it looks like the odds of a Fed rate hike in December jumped by about 15%, (currently 55%).  I appreciate that the Fed is trying to base their policy on real time data.  The problem is that they seem to have bought into the fear that they are the cause of high equity and home values.  And, they treat high rent inflation as a monetary issue, when it is a supply issue.  So, I think they are sincerely trying to follow the data.  But, the problem is that these conceptual errors bias them toward wanting to raise rates.  So, it doesn't really matter if they are trying to follow the data.  If the data follow some stochastic process, and each time there is data noise, the Fed adjusts their expectations with even a slight bias, the trend of those expectations will still be mainly an effect of that bias.  So, at some point, they will be convinced that we need another rate hike because that is their bias.  Probably just as well that it's December as opposed to next year.  We might as well get it over with if it is inevitable.

Housing: Part 258 - YOU rigged the economy.

Maybe this is repetitious, but I'm not sure if I have written about this is exactly this way before.

Consider two of the most widely and strongly held opinions about the financial crisis:

1. The system is rigged.  We bailed out the banks who did this to us, and we left Main Street and regular families high and dry.
2. We have prudently put new safeguards in place in order to prevent the reckless lending and speculating that caused the bubble.  One fortunate result of the federal takeover of the GSEs, the passage of Dodd-Frank, and the collapse of the subprime market, is that lenders are now much more selective about who they sell mortgages to.

Think about that for a minute.  What were the bailouts, really?  There were a few examples of the government basically taking over the equity position in some firms, generally at a profit.  There was general monetary accommodation.  And, there were various emergency loans.  Generally, in panicked markets, the Fed was engaging in one of its core roles - acting as lender of last resort.

Basically, the government loaned money to various firms and financial institutions, to make a liquid market, expecting to earn a return on those loans.  And, in the end, it generally has.

So, if the government had treated both "Wall Street" and "Main Street" the same, then, what would it have done?  It would have funded mortgages in illiquid markets as a sort of lender of last resort, expecting to earn a return.  So, then, why didn't it do that?  The answer: See point two above!

The reason the government didn't "bail out" "Main Street" is because we wouldn't stand for it!  Consider the oddity.  It's like we insist on not having our cake and being upset about it too.

At exactly the same time that the federal government was funneling trillions of dollars to "Wall Street", it was knocking the wind out of middle class housing markets at Fannie and Freddie.  After the takeover, the GSEs completely eliminated any growth in mortgages outstanding for FICO scores under 740.  This, coming on the heals of the complete collapse of the subprime and Alt-A securitization markets that had been serving some of that market.

In a panicked market, the federal government turned out the lights, and we cheered for it between our complaints of rigged markets.

Given this situation, what could the federal government have possibly done to mimic on "Main Street" what they had done for "Wall Street"?  We wouldn't dare let them be an actual lender of last resort.  That left a bunch of unlikely and costly second best options that were never going to amount to much.  And, so we complained that they weren't trying hard enough.

The lack of any reason for this becomes more clear as we realize the full picture of the markets of the time.  The new paper from  Stefania Albanesi, Giacomo De Giorgi, and Jaromir Nosal is just one in a line of papers that show the owner-occupier market was not in need of retraction.

This is clear even in basic national survey data, like the American Housing Survey and the Survey of Consumer Finances.  Homeownership had peaked in 2004.  The number of first time homebuyers had been declining pretty steeply since 2005.  There had never been any expansion of homeownership among households with lower incomes who would have difficulty making payments.

And, because the federal denial of a lender of last resort was so targeted at these credit constrained households and neighborhoods, it was the period after this when home values really collapsed in those markets.

There was a housing contraction in 2007 and 2008, and a financial crisis in late 2008.  Then, because of belief number 2 above, there was a third crisis in 2009 and 2010 that was actually more severe than the main housing contraction we all recognize.  That crisis only hit working class neighborhoods.  We rigged the system, and we're still patting ourselves on the back for it and demanding that someone, somewhere, correct this vexxing injustice.

We were nearly unanimous in our opposition to a Main Street bailout.

Housing: Part 257 - Practically everyone predicted a housing bust.

I will chalk this up as one more tidbit of the housing boom and bust that is sort of the opposite of conventional wisdom.

A frequent complaint I hear about the crisis is: How did economists and policymakers miss this?  How did a crisis so severe sneak up on us when the (supposed) excesses of the bubble made it inevitable?

Here is a great graph from Leonard Kiefer of forecasts of housing starts since the late 1990s.

Even as far back as the late 1990s, the median forecast was for declining housing starts.  At that time, housing starts had only just recovered enough from the declines of the early 1990s to get back up to long term averages.  Yet, the consensus was already looking for a downturn.  And, of course, even today, you frequently see people claim that they called the bust as early as 2002 or before.

Calling the bust in 2002 was the consensus!  That's why so many people feel vindicated by the bust.  Most people were calling it, and markets kept defying them.

The problem wasn't that nobody saw a bust coming.  The problem was that there was no need for a bust, but the country had been so bound and determined that surely one was due, that the market's defiance of that expectation in 2004 and 2005 created extreme expectations.  If a bust was due in 2000, imagine how much we needed a bust by 2005!  And, not only had housing starts continued to rise in defiance of expectations, but prices did too.

So, when that terrible collapse started in 2006, the collective reaction was not a demand for stability.  It was a collective demand for letting nature take its course.  Finally, years' worth of expectations were vindicated.  And, the delay it took in coming meant that it might take a mighty correction to unwind the excesses that surely had built up over time.

Even after all that has happened, and after a decade long over-correction, this still appears to be the bias.  I expect that we will see downward expectations again before homebuilding ever reaches a sustainable level again.  We already see reports of overheated markets in the Closed Access cities, where housing starts that can't even accommodate natural levels of population growth look like building booms to locals who have spent a generation or more in deadened cities.  And the high prices caused by the housing shortage only seem to them like further evidence of a mania.

Housing: Part 256 - Your Occasional Reminder. It's Housing.

This is your occasional reminder that the stagnation we are experiencing is housing.  Investment outside of residential fixed investment is basically normal.  Residential investment could be 1% to 2% more of GDP for a generation than it is right now.  We are currently in a regime where people are talking about macroprudential moderation because housing is getting too hot.  So, stagnation will continue for the foreseeable future.

Investment outside of residential investment will probably continue to be normal, and total investment will continue to move along the bottom of the long term range.  And, we will continue to have the "mystery" of low interest rates until this ends.

Housing: Part 255 - Relative Valuations Across MSAs and Across Time

Suppose we start with a basic valuation model such as:

Here, I am using the median home price for each MSA and the median rent for each MSA.  (Both available from Zillow Data.)  Rent, I have reduced by 50%, to arrive at a rough estimate of net rental income estimate, after costs and depreciation.
I have estimated property tax rates from here.
The growth rate here would be the future expected of MSA rent inflation above the general rate of inflation, which is an unknown.
And, the required rate of return is an unknown.  Here I will write in terms of real yields.

I have shown that across MSAs, price appreciation has been highly correlated with rent inflation.  This is true regardless of the sensitivity of home prices to real long term interest rates (which can be used to estimate the required rate of return here).  In that analysis, I used estimates of the required rate of return to solve this equation for the expected rent inflation (growth rate).  That is where I find the correlation (expected rent inflation across MSAs correlates strongly with past rent inflation.)

Here, I want to go the other direction.  Let's plug in various growth rates and see what sort of returns on investment that implies across MSAs at various points in time.  These are 17 MSAs that we have rent inflation data for from the BLS.

Here, I am going to use 1995, 2005, and 2015.

In 1995, rent inflation had been moderate for a decade, generally, across MSAs.  So, for 1995, I am assuming zero expected rent inflation in every MSA.

In 2005, the light red dots here show the required rate of return if there is no expectation of rent inflation.  The dark red dots show the required rate of return if expected future inflation is equal to the excess annual rent inflation for each MSA from 1995-2005.

In 2015, the light blue dots show the required rate of return if there is no expectation of rent inflation.  The dark blue dots show the required rate of return if expected future inflation is equal to the excess annual rent inflation for each MSA from 1995-2015.

In all cases, the large dots are the US median.

In 1995, this puts the US median required return at 3.5%, which is slightly less than real long term treasury yields were at the time.

In 2005, if we assume no expected rent inflation, the US median required return dropped to 2.4%.  From 1995 to 2005, real long term treasury yields dropped by about 2%.  Glaeser, Gottlieb, and Gyourko find that home prices change by about 8% for each 1% decrease in yields.  That is about 40% of the sensitivity of a 30 year bond.

The dark red dots reflect expected rent inflation that is 100% of recent past inflation, which is too aggressive.  On the other hand, the light red dots reflect no rent expectations, and they suggest that home prices are somewhat more sensitive to long term interest rates than Glaeser, et. al. estimate.  The downward slope would also suggest that the supply constrained cities are more sensitive to rates than less constrained cities.

In 2015, we find the same patterns, except that since we triggered a nationwide liquidity crisis in housing, the implied yields for housing are high, in spite of the low yields we see in treasuries.

If we just had the 2005 data to go on, we might come up with decent explanations for why home prices in constrained cities are more sensitive to long term interest rates.  But, this explanation is a little harder to defend in 2015, because yields in general for housing are not low.  What would cause yields in less expensive cities to rise while yields in more expensive cities decline?

If we split the difference with real yields and with rent expectations - so that home prices are somewhat sensitive to yields, but also somewhat sensitive to rent - the 2005 dots would basically settle halfway between the two versions here.  That makes intuitive sense, and it suggests that prices across cities generally reflected reasonable estimates of yield and rent factors.

I think we would expect, with 20 years of established rent inflation, for rent expectations to be stronger by 2015, and with the sharp controls on mortgage markets, yields would be less influential.  So, in 2015, the dark blue dots that reflect a stronger effect from rent expectations are probably a more realistic estimate of implied yields.

An easy quick way to read the graph is that, basically, the vertical difference between a light dot and a dark dot is the expected excess rent inflation.  So, if a light dot is at 3%, that means that the home will provide net rental income equal to 3% of today's price.  If the dark dot is at 4%, then that means the homebuyer is actually expecting to earn a 4% real return.  3% will be in the form of income and 1% will be in the form of annual capital gains as rent increases.

(Considering that mortgages can be attained, for the "haves" who have access to credit in post-crisis America, with real interest rates of about 2%, leveraged ownership of residential real estate seems like a real bargain.  That makes sense.  In a context defined by credit rationing, those with credit access will earn alpha.)

In short, there is nothing about the housing markets across cities over this time that can't be explained by moderate sensitivity to broadly recognized valuation factors.

One more item we can look at here is the effect of different factors.  Once we have plugged in a growth rate and solved for required return, we can adjust each factor to see what effect it has on price.

In this last graph, the blue line is the median 2015 home price for each MSA.  The cities with supply problems and high prices also tend to be cities with low property taxes.  This is probably no accident.  The low tax base means that expanded residential housing is seen as a cost to local municipalities instead of a potential revenue source.  This is quite explicit in housing debates around Silicon Valley.

Here, the red line is the hypothetical home price these cities would have if they raised their property tax rates to the same level that Dallas has.  The green line is the hypothetical home price in each MSA if there was no expected future rent inflation (all else held equal).  And the purple line is the hypothetical price if each city applied Dallas' property tax rates and also had no expected rent inflation.  There would still be some difference between cities, because current rent levels are much higher in some cities than in others.

I think it is interesting that the shift in property taxes has as much of an effect on property values in this model as rent inflation does.

Keep in mind, though, that property taxes don't really make homeownership any more affordable.  It just shifts your payment from the mortgage financier to the local government.  You could think of property tax, really, as a partial public ownership, with a fixed income claim, much like a non-recourse negative-amortizing mortgage.

While property taxes only improve the illusion of affordability as a first order effect, because the public (incorrectly) treats home prices as an affordability signal, the most important effect of higher property taxes would probably be the secondary effect that it would induce municipalities to allow more generous new supply.