Is Inflation Running Hotter Than we Think?

Yesterday’s CPI report confirmed what most people think – inflation is running much cooler than most presume.  This isn’t shocking when we consider the high unemployment rate, the low capacity utilization, the substantial output gap and the generally sluggish conditions.  Producers just don’t have a huge amount of pricing power given the weakness of aggregate demand.   But inflation isn’t always an even phenomenon and asset price inflation has become an increasingly dangerous phenomenon in recent years.

Of course, this has been nowhere more apparent than it is in the real estate market where soaring prices only just recently led to a near collapse in the US economy.  And while I became fairly bullish on housing last year I have to admit that the level of the rally in real estate has been very surprising.  Prices are up 12.2% year over year according to CoreLogic.

Of course, this is a tricky way to view inflation because the BLS doesn’t count housing prices as consumption, but investment.  I don’t think the investment/consumption view of real estate is quite so black and white which is why I embed real estate prices in the Orcam Housing Adjust Price Index.  The latest reading on the OHAPI is showing 4% year over year inflation.  That’s more than double what the CPI is saying.

Now, this might not accurately reflect a price basket as well as the CPI does, but inflation is always and everywhere an uneven phenomenon and asset price inflation in the consumer’s most important balance sheet item is worth keeping an eye on.  Had we tracked something like the OHAPI in the early 2000’s we would have never fallen for the idea that inflation was low during the biggest housing boom in US history.  Had the Fed been viewing price changes through a gauge like this they might have been faster to tighten policy and get ahead of what was clearly a dangerous trend.

Are we getting into a dangerous environment like we saw in 2007?  I certainly don’t think so quite yet, but Fed policy should be proactive and not reactive.  To me, the path forward appears obvious.  I think QE is having more destabilizing than stabilizing effects here and the Fed could probably do a great deal to cool real estate trends before they potentially get out of hand again by simply ending the QE program.  The Fed could maintain ZIRP, but eliminate what is perceived as an asset inflationary policy.   I don’t think inflation is at risk of running out of control here, but the uneven price action in some markets is something we should be aware of before it’s too late.


 (Orcam Housing Adjusted Price Index via Orcam Research)


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Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services. He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.

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  1. How are real estate prices soaring if incomes are stagnant. That’s what I want to know.

  2. Probably just speculation. The idea that housing is a good investment is something that is driving purchases at present as people still think they’re getting in before prices have boomed. But they’re booming in many areas.

  3. It’s an interesting way to view inflation, but not the traditional view. Economists view real estate as investment and not consumption. Therefore, it doesn’t get included in the index and your definition is not “inflation”, but “inflation” plus an asset price.

  4. Yes, I am aware that some economists would take issue with what I’ve done here. I am just trying to provide an alternative view to what I believe is an incomplete view of real estate trends as they pertain to the consumer’s balance sheet. I personally don’t view real estate as pure investment, but also a form of consumption. That is, you generally invest in the land, but you consume the actual house itself. The house is really no different than a car. Except, of course, with a car you don’t get a plot of land. So there’s elements of investment and consumption in real estate, but most economists just refer to it as pure investment, which I don’t think is totally clear. So I guess it’s a matter of definitions.

  5. “Specuflation” (patent pending) might work as a definition!

    In Canada, the poster boy is La La Land (sorry that’s what we call it) Vancouver:

    This month I started publishing a Bank of Canada 10 year “real” yield to see if I could spot a leading tell:

    … inflating real yield in Canada against deflating Gold, Energy…. and what might be a turn down in the TSX Real Estate Index.

    Real estate may be coming off the boil up here which for a change might be in concert with the US Real Estate market mini boom that some observers say is cooling.

    It probably depends on if Big Money can continue rationalizing negative yields from real estate as treasuries become more appealing.

  6. “Specuflation” (patent pending) might work as a definition!

    In Canada, the poster boy is La La Land (sorry that’s what we call it) Vancouver:

    Real estate may be coming off the boil up here which for a change might be in concert with the US Real Estate market mini boom that some observers say is cooling.

    It probably depends on if Big Money can continue rationalizing negative yields from real estate as treasuries become more appealing.

  7. its out of town money. its money of which there is no record and never has been. there is also the small matter of the baby boomers’inheritance. Our parents, the blessed ones, left us a lot of money. some of we used, but a lot of it is being used to purchase homes for the off spring of babyboomers.

  8. I see. The cost of maintaining the house and the mortgage can actually be a huge change in the cost of living so its not accurate to claim that price appreciation in RE is automatically reflected by underlying positive trends, but probably a mix of an increase in cost of living as well as value.

  9. How true. Yes, we do consume housing. We need it to live a decent, health life. If we don’t have a place to live, how will we survive and thrive. it ought to be considered as part of our living expenses and thus included in inflation. Not everyone owns homes, so where would that leave them, with traditional thinking.

    it is easy for governments and other organizations to leave housing out of the equation. It makes it look like inflation isn’t as high as it actualy is. This is important for large corporations and governments. Many retirees, pensions are indexed to the cost of living. if it can be demonstrated that the cost of living is lower, than those who pay out, get to keep a lot more money. If the cost of living/inflations is growing, the government and corporations will have to pay out more money.

    Its quite simple actually. If the cost of housing were considered as part of inflation/cost of living and it went up 12% then seniors pension would go up by the same amount. If inflation/cost of living is kept to 2% than that is all your pension increases. This also applies to those who are living on disability pensions and benefits.

    The government figured this out eons ago and it has benefited from it. it applys to things such as E.I. payments, welfare, etc, monies paid to First Nations. The government and some large corporations save a bundle.

  10. Yeah, it’s likely that the index was changed specifically to reduce the huge cost burden imposed on corporations after the 70’s. The corps own Congress so it would be beneficial to them to index inflation in housing to something stable and slow to appreciate like rents.

  11. The first problem is the widespread acceptance of CPI as a measure of inflation. Inflation is *defined* as an increase (or inflation) of the **Money Supply**.

    The 2nd problem is, of course, QE. It’s a hideous attempt at propping up housing and equity markets by giving enormous sums of money to the Fed member banks, and letting them use it for proprietary trading. It’s a welfare program for investors at the expense of taxpayers, and our children & grandchildren.

    Trouble is, if QE stops, equity markets and asset values crash. Hard.

    QE makes the Fed the purchaser of last resort for US Treasuries, which keeps interest rates abnormally low, and keeps housing values high. When QE stops (or slows), mortgage rates go way up, and values come crashing down. Hard.

    We have a horrifically unbalanced economy that depends on massive doses of QE liquidity to function — but at some point, the addict has to look in the mirror, face reality, and check himself into rehab.

    That’s the other problem — the net worth of what’s left of our Middle Class is utterly dependent on continued, and increasing, injections of QE.

    Cullen, you’ve done well to count housing as an expense for “inflation” purposes, because increased housing costs have the effect of suppressing Consumer Demand.

  12. Problem – CPI doesn’t reflect what most feel.

    Frequently, people tell me inflation is high, far higher than government reported. I explained to them that CPI doesn’t run wild but let’s see:

    1. Food and gas price up – directly hit almost everyone as they buy them at least weekly if not daily

    2. Computer prices fall hard – most don’t feel the impact since they don’t keep buying computer

    From what I see – lots of manufactured goods’ prices actually fall. This deflation hit hard in many industry but fortunately, they are transparent to USA as they are mainly produced overseas. I see plenty of less than $10 clothes in deep discount stores. It would be better to construct a consumer index (government won’t) which reflect people’s living expense by:

    1. Create price index for well to do, middle class, and poor – yes, 3 index

    2. Put tax, education, house price into each index according to proper weight reflect that class

    There is an incentive for government to under report CPI to lessen expense base on indexing CPI.

  13. Ok, I compared my expenses today versus my expenses from a year ago. I was able to track and compare about 70% of my expenses.

    My own personal inflation is about 4.5%.

  14. CPI has been running ahead of house prices for the past several years. Cullen’s O’Happy index may simply be reflecting a catch-up. This is a situation where “price targeting” is probably superior to “inflation targeting”. If you look at a long term chart of the house price index level versus the CPI index level, you will see that they generally track pretty closely. However, over the past few years, the house price index has fallen well below CPI. Even after the recent rebound, the house price index level is still below the CPI index level, and therefore appears to have further to run.

  15. Subtract medical premium out of the equation and my personal inflation is slightly above 3%.

    It’s doubtful the government is figuring in medical premiums.

  16. Let’s see. I am paying more for the following than I did last year:

    – gas for my car
    – cable
    – food
    – electricity
    – clothing

    Over that time period, my wages were frozen (as they have been for the past 4 years). Oh, and I was just informed I will LOSE pay starting Oct 1 because my employer is going to start furloughs.

    You want to claim no inflation? When General Mills now wants to sell me a 9oz box of cereal for $4? And my wages are going nowhere?

  17. 1) There is no systematic relationship between monetary policy stance and real house prices across countries:

    So you appear to be claiming that unconventional monetary policy has effects which even conventional monetary policy does not have.

    2) There is no evidence of a relationship between QE and house prices across currency areas. Since 2008Q2 the monetary bases of the US and the UK have been increased by 260% and 348% respectively. In contrast the monetary base of the eurozone has only been increased by 43%. (The ECB has never done and has no plans to do QE.) From 2008Q2 to 2013Q1 house prices have fallen by 9.0%, 5.0% and 2.3% in the US, the eurozone and the UK respectively:

    And until 2012Q3 house prices had fallen less in the eurozone than in the UK, so prior to that house prices fell more in the currency areas that did QE than in the currency area that did not.

    True, the increase in nominal house prices was smaller in the eurozone (up 82.5% from 1995 through 2007) but if anything it was more widespread with only Austria and Germany not having large increases in house prices:

    So it is not the absence of an increase in house prices that explains the slower rate of decline in the eurozone.

  18. Real estate is the area where wealth inequality has the greatest effect. We have a small minority of people with means bidding against each another for RE (for investment purposes), raising prices for the average Joe in the process.That’s how we can have rising prices despite stagnant wages.

  19. Good afternoon Cullen.

    I have one question, and not being an `expert` on MR, the answer may seem obvious to some, but – knowing we have established the excess reserves are a constant downward force on rates, I am curious how the FED could maintain a ZIRP environment while stopping QE..??

    Any feedback appreciated,
    Sned, England.

  20. Cullen,
    You state above that “the Fed could probably do a great deal to cool real estate trends…by simply ending the QE program.”
    But you’ve stated several times before that QE is a great non-event and we saw in the past that at the end of QE2, rates actually went DOWN dramatically. Why do you think ending QE3 (or QE infinity) would cause the real estate market trends to “cool”?

    Thanks in advance.

  21. It’s a messy problem. I see your point, Cullen, and I think it’s valid.

    But it’s only a cost of living increase for people who are buying a new home. And I guess eventually, maybe for renters, if landlords can justify higher rents based on equivalent ownership costs (but that seems fairly sticky).

    For folks who are locked in with a fixed rate mortgage, or who own their property outright, housing price increases don’t increase the cost of living.

    Maintenance costs may or may not increase equally. But I suspect they are indirectly tracked by costs in other sectors anyway. Property taxes might increase. That’s an increase in cost of living, but possibly deflationary economically.

    For locked-in folks, an increase only shows up if/when they decide to buy a new home. And at that point, assuming they also sell their old one, they should have benefited from price appreciation there, so a new house might not actually lead to a cost of living increase. This would certainly apply to retirees, boomers, etc, who are “downsizing”.

  22. The Fed can reduce its securities purchases and maintain ZIRP by paying 0.25% on interest on reserves. The IOR rate is the de facto Fed Funds Rate as long as it’s being paid. So think of the Fed’s balance sheet size and FFR as two separate things. The Fed can always control rates as long as it’s paying IOR.

  23. I think QE doesn’t have any fundamental impact, but it does have psychological impacts. A speculative fervor is largely a psychological thing so while I don’t think ending QE would end all speculation in any markets I do think it’s a potentially unnecessary contributor to it. Remember, QE is basically the Bernanke Put in play. It’s the idea that the Fed won’t let asset prices fall. That’s really all it is. If the Fed reduced their stance there it would probably make markets react a bit more normally.

  24. Don’t you think higher house prices reflect the changes in the costs to upkeep a house. For instance, if my roofing starts to deteriorate over the years and I want to replace it with what updated houses have then that is reflected in the price of new homes. If I want to upgrade my kitchen then that’s reflected in the cost of new homes.

    I think people forget that the actual house itself is a depreciating asset built from pieces that are falling apart every day. If you own a home you know exactly what I mean. The cost of upkeep can be enormous, but no one tracks all these costs as they go about valuing their house. They just think “oh, I bought at $X and will sell at $Y. ” No one considers the costs of owning when calculating these variables….That’s why I think the price of a house does very accurately reflect someone’s cost of living. In fact, it is probably most people’s largest expense by a wide margin….

  25. Not to go too far off the rails, but I just read this example last week of a guy who did actually track and document this. Long read, but interesting, I think: Now just imagine if his house price stayed stagnant, or even decreased during that time.

    As for “Don’t you think higher house prices reflect the changes in the costs to upkeep a house.”

    Hmmm, I wasn’t looking at your argument from that perspective before. When you word it this way, I understand it better. That is a possibility.

  26. Hmmm…I certainly agree with you regarding the psychological impact QE has on markets, but I would venture to guess that ending QE would hurt equity markets and hurt the so-called “wealth effect” narrative. However, I would think rates would then fall further and that could theoretically aid the housing market. But then…ugh, my head hurts.

  27. Oops, I made a cut and paste error in my previous comment.

    This was supposed to be the first paragraph:

    Yes, I absolutely agree that a house is usually a poor, or at least poorly understood ”investment”. They can have huge maintenance costs. I’m in my second owned home now, and I see this first hand.


  28. If housing was only an investment you would not need to continual maintain the asset. A general rule of thumb is to plan to spend 1% of the homes value per year on upkeep. Cullen, I think your approach is more inline with reality.

  29. Thanks Cullen,

    I must be missing something here…!!??
    If it were that simple a relationship, why does the FED need to buy and sell treasuries at all to maintain low rates..??

    Am I confusing the meanings of definitions maybe..??

    Thanks again.

  30. Thanks Cullen,

    I must be missing something here…!!??
    If it were that simple a relationship, why does the FED need to buy and sell treasuries at all to maintain low rates..??

    Am I confusing the meanings of definitions maybe..??

    Thanks again.

  31. Indeed, and it’s not exactly like there aren’t many different valid interpretations or definitions of inflation itself.

    My Consumer Purchasing Power Loss Index (CPPI) is running at 4.8% and also includes adjustments to the OER madness.

  32. May have this wrong, but…

    Buying and selling treasuries is how the FED has traditionally set rates. IOR came about as a result of the ZIRP environment.

  33. Thanks for the chart. It confirms what I’ve seen, that medical premiums have been going up at a 7 to 9% annual clip the past two or three years.

    So if you take a typical family of four earning an income of 100k and with a 17k medical premium, the increase in medical premium is 1.4% of their income. So how is the government coming up with a 1.5% inflation rate?

  34. I agree with Cullen that some portion of real estate ownership is consumption, but I think a potential problem with incorporating it into an inflation index is a lack of ability to quantify how much of the $s that go into RE have anything to do with consumption vs paying a mortgage.