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How Housing Lowers CPI

Tony Crescenzi had an interesting article on RealMoney this week. In it, he notes that as the housing market soars, it ends up knocking rents lower. After all, why rent if ultra low real interest rates allow you to buy for the same price, and with nearly no money down?

So what's the problem with that? It turns out that rental prices account for 30% of the core CPI. As we saw last month, this was zero flat.

How's that impact the perception of inflation? Crescenzi observes:

"Surging housing demand appears to be continuing to reduce demand for rental units, weighing on the OER component of the CPI. Strength in housing demand is apparent in the recent data on mortgage applications for home purchases, wherein the four-week moving average is now at a record high, as well as the National Association of Homebuilders' latest housing market index, which in May reached its second-highest reading in five years. Meanwhile, rental income has fallen to about $147.8 billion from the peak of $186.6 billion in April 2002. When the housing market weakens, it will result in increased demand for rental units, hence boosting the OER portion of the CPI."

The Federal Reserve commissioned a 52-page study on the subject. In it, they discussed the impact of housing demand on the OER component of the consumer price index. They found:

"Downward pressure on rental prices mainly resulted from an increase in demand for homeownership, which was spurred by historically low mortgage interest rates (see Figure 19). As housing starts and home sales surged in the recent recession and recovery, the national rental vacancy rate jumped from 7.8 percent in the fourth quarter of 2000 to 10.2 percent in the fourth quarter of 2003. This effect was compounded by the way owner-occupied housing prices are measured in the CPI. The CPI uses a rental-equivalence approach, measuring the value of the shelter services an owner receives from his or her home. Price movements in owners' equivalent rent reflect changes in prices of rental units that are comparable in characteristics to owner-occupied homes. Therefore, increased demand for homeownership put downward pressure not only on tenants' rent but also on owners' equivalent rent -- the largest component in the CPI."

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Figure 19
click for larger chart

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Crescenzi adds this coda:  "Note that when mortgage rates go up, demand for new homes presumably falls, hence boosting the demand for rental units and thus boosting rental costs and the CPI."

That's right folks, the low reported inflation is courtesy of a hot housing market. As most people have figured out for themselves, inflation is still alive and kicking..

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Source:
How Housing's Surge Is Suppressing CPI
Tony Crescenzi
RealMoney.com, 5/18/2005 12:59 PM EDT http://www.thestreet.com/p/rmoney/crescenzioncredit/10224145.html

Saturday, May 21, 2005 | 03:43 PM | Permalink | Comments (3) | TrackBack (4)
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Comments

---After all, why rent if ultra low real interest rates allow you to buy for the same price, and with nearly no money down?---

This doesn't jibe at all with my experience here in California, nor I imagine in most if not all of the "hot" real estate markets today.

In my area, homes rent for an avg of 35-40% of the cost of a conventional mortgage and related ownership expenses. If you opt for "creative" financing, you can narrow the gap. But renting is still far cheaper and you face the certainty of increasing mortgage payments down the road. And by opting for interest-only, you are eliminating one of the main positives of ownership: building equity.

I also seriously question Crescenzi's theorem that rents will rise as home prices stagnate or fall, particularly in speculator-infested markets. I believe the opposite will occur, at least at first. That's because when these markets down south, there will be a flood of homes coming on the rental pool, either via speculators who can't sell or the banks who now own these homes.

Posted by: loret | May 21, 2005 9:13:14 PM