What Should the "Basket of Goods" Really Be?

[HB Reader]

HB Reader, I think you made yourself perfectly clear, I just respectfully disagree.  In a nation where 65% of families are homeowners (formerly 67%), any inflation statistic that ignores the increasing price of housing seems fundamentally flawed.  I realize that rent equivalence may be acceptable to the rest of the world, but in most of Europe and Asia a large percentage of people rent, so it seems perfectly natural to use that comparison.  In the US, where home ownership is looked as as the "American Dream," and huge tax and government incentives exist to encourage home ownership, I think it is disingenuous to remove house pricing from total inflation statistics.

I see that you're saying CPI measurements don't really reflect the true cost of living, but doesn't that seem wrong to you?  When pension and retirement benefits are based solely on CPI measurements that fail to give any weighting whatsoever to the largest expense that most Americans have each month, doesn't that seem wrong?  Housing has a deep and profound affect on each person's bottom line, as it is most likely the largest expense we will have throughout our lives.  To discount this completely and turn us into a nation of renters just seems wrong to me.

Storm --

I hate to sound argumentative, but are we both referring to the same CPI?  To say the CPI fails "to give any weighting whatsoever the largest expense most American have each month" is simply not correct.  Where I live in Northern Virginia (and everywhere else I've lived in the US for the past 40 years) trends in local home rental rates track trends in home sales prices pretty closely.  The CPI results do not "discount completely" or "remove" or "ignore" increasing or decreasing home prices.  The CPI measurement just does not track home sales prices directly.  And, for what it's worth, home ownership rates in many other countries are actually higher than here -- including the UK, Canada, Australia, Ireland, Italy and Finland -- and in the same ballpark (over 60%) -- in Japan, Sweden and Belgium.

I get your point about the "American Dream" and I understand many other people have the same opinion of the CPI as you.  You're right, I guess we just disagree.

I do know contructing a true cost of living index is much harder than it appears on the surface.  I also know the folks at BLS (and many of their critics, as well) spend a lot of time and do considerable research on this issue.  I also know the BLS thoroughly researched the issue before switching from directly tracking sales prices to tracking rental equivalence in 1983 and had received much criticism by prominent economists (e.g., Barry Bosworth) and others in the late 1970s/early 1980s who thought the direct way overstated the yearly change in prices for most consumers.  In fact, about 10 years ago when my wife was working on the Producer Price Index ("the PPI"), she looked into using the Case/Schiller data series in producing the index, but they found a number of methodological flaws in that as well.       

[moda0306]

I'm torn on this issue between Storm & HB reader.

Rents and mortgage payments saw a large spreading effect during the housing boom.  This would skew data to only include rents.  It seems totally unfair, as a decent portion of the population's now buying more expensive homes... it wouldn't be a very accurate "basket."

That said, when housing rises is it really inflation for 65% of the home-owning population, or simply inflation for the ??% that purchase a home during that time.  It's too much of a one-time purchase to fit it neatly into CPI.  Rents (theoretically) should do a much better job, but somehow that whole relationship got royally skewed in the housing run-up.

So for CPI, if we use housing instead of rents or as a 65/35 split or something, we're still left with the fact that a huge portion of the home-owning public was paying no more for housing in 2005 than they did in 1996, because they're simply paying down the same mortgage or have already fully paid it down.

[Storm]

Yeah, it's like HB Reader said - you can't just assume everyone is buying a new house every year and getting a brand new mortgage.  I can see how it would be difficult to scientifically model it.  I'm willing to concede that rent equivalence is probably the best we can do, statistically speaking.

Personally I just wish we could get over all of this market meddling and let the housing market correct itself finally so that the wife and I could buy one without losing our shirts due to leverage.

[fnord123]

Owner's equivalent rent is about 24% of the CPI weighting I believe, and the contribution to inflation of OER over the last few years has been small (1% rent changes * 24% weighting --> 0.25% addition to inflation).

If we were to switch to house prices (e.g. Case-Schiller), we would  have seen negative 5 to 10% (depending on the year) changes to house prices * 24% weighting --> negative -1.25% to -2.5% contribution to CPI-U.

Given the above, do the folks who are pro-house prices (and anti OER) believe we are experiencing more like 0.5-1.5% inflation, rather than 2-3.5%?

[moda0306]

Good point fnord... the "inflation" of housing would now be more "deflation," and would skew things for everyone other than those popping into the housing market today...

The dog just don't hunt.

This isn't to make light of the tragedy that is those who bought a home in 2004-2007.  I probably would have done the same if I'd been at the right stage in life.  It was hard to believe that housing could tank, despite all the evidence.

[MediumTex]

I probably would have done the same if I'd been at the right stage in life.  It was hard to believe that housing could tank, despite all the evidence.

And I guess that's why bubbles continue to form, no matter how much we know about historical bubbles and how in retrospect they all sort of look the same.

[Storm]

MT, I really disagree with where that trendline is drawn.  The 100 number is already inflation adjusted, so unless they are correct that housing always rises faster than inflation, they are wrong.  It appears that they are drawing a trendline through previous housing bubbles and predicting that the bottom of this bubble will be somewhere in the middle of previous bubbles.

History has shown us that housing bubbles, and any bubbles, always overcorrect to the downside after deflating.  This is a much more likely graph:

[moda0306]

It always helps to have a constant.  Rents, for instance, didn't rise nearly as fast as housing and that could provide huge evidence... same with wages... this could have been a permanent adjustment, I guess, do to lack of land availability (here in MN lake-shore property was on an absolute tear because people thought they'd NEVER get to see that cabin on the lake or that lake home).

So people can justify it saying "we're running out of space to build stuff, so this adjustment is appropriate."  If not for the demographic collapse at the bottom end, this would probably be valid.

With the .com boom, PE ratios and other ratios were way out of line, but "it was different," because tech stocks had SO much intellectual property that normal balance sheets couldn't really capture.

Same with gold (and the aversion to bonds) in the early 80's.  Buying a 30-year treasury, even at 12%, after a decade-long decline was bound to be a bad idea if inflation keeps climbing.

Bubbles are filled with government-induced moral crises, political biases, private-sector greed, groupthink, and recency bias, none of which are ever in short-supply.

[moda0306]

So will rents actually drop, or will housing become a pretty good deal soon enough?

Also, are we going to go back to 50% LTV like in the 30's, 80% LTV, or 90% LTV before prices turn back around?  I doubt a complete deleveraging will occur where we go back to paying cash for a home, but where it DOES go back to will drasticly affect housing prices IMO.

If people are able to put 3.5% down or even 10% down and move into a place for less than what they'd pay for an apartment if they'll have the place paid off in 30 years, I think they'll often do it.  If that's enough to get prices stabilized for a few years, I bet people will forget about a double dip at that point.

So I guess I'm saying that I think it LARGELY depends on where rents go.  If they stay at $1,000 per month for a decent 2BR for me in the cities, and the FHA stays in tact, I think things will hit a floor relatively soon.  If people can get that apartment for $750 in a couple years, it could be very bad for housing.

[MediumTex]

MT, I really disagree with where that trendline is drawn.  The 100 number is already inflation adjusted, so unless they are correct that housing always rises faster than inflation, they are wrong.  It appears that they are drawing a trendline through previous housing bubbles and predicting that the bottom of this bubble will be somewhere in the middle of previous bubbles.

History has shown us that housing bubbles, and any bubbles, always overcorrect to the downside after deflating.  This is a much more likely graph:

Wait a second, both of those trendlines look the same to me.

Am I missing something?

The only real point I was making in posting the graph was that as we neared the peak in 2006-2007, it looked a lot like every other parabolic rise you see with other historical asset bubbles.  It's funny that so few people were able to see it at the time, but I guess that's what made it a bubble in the first place.

[Storm]

MT, I really disagree with where that trendline is drawn.  The 100 number is already inflation adjusted, so unless they are correct that housing always rises faster than inflation, they are wrong.  It appears that they are drawing a trendline through previous housing bubbles and predicting that the bottom of this bubble will be somewhere in the middle of previous bubbles.

History has shown us that housing bubbles, and any bubbles, always overcorrect to the downside after deflating.  This is a much more likely graph:

Wait a second, both of those trendlines look the same to me.

Am I missing something?

The only real point I was making in posting the graph was that as we neared the peak in 2006-2007, it looked a lot like every other parabolic rise you see with other historical asset bubbles.  It's funny that so few people were able to see it at the time, but I guess that's what made it a bubble in the first place.

Point taken - I am disagreeing with the green trendline, not the red or blue (which are scaled versions of the previous bubbles) projection.  Although, you will note in your graph, it predicted we would be at 110 on the Case/Shiller index in 2011, when we are actually still at 140.

This is a fascinating indication that all the government stimulus is really like you said, "a man with a firehose on the beach trying to stop a tsunami." (forgive me if I misquoted)  They can try to put off the inevitable, but all it does is delay the pain.  We should have hit the bottom in 2011, according to 2006 projections, but now it looks more like 2012 or 2013, or even longer if they keep throwing money at the issue.

I wonder when our government will get it through it's head that housing affordability is the problem, not low house prices.  It's pretty frustrating to me, as a renter who would like to own a home someday, to be unable to buy one without losing my shirt due to leverage, while the government continues to spend my tax dollars trying to reinflate bubbles.

[moda0306]

Storm,

If you're still a renter, feel at least a little lucky.

[Storm]

Storm,

If you're still a renter, feel at least a little lucky.

Absolutely, we are lucky we didn't buy in 2006 or 2008 as I wanted to, but saw the market was frothy and decided against it.  The frustration comes in realizing that we will have to wait at least 7-8 years (from 2006) to buy a house.  The housing market moves in 10 year cycles anyway, and whatever government money comes into place will just delay the inevitable.