Friday, April 17, 2015

March 2015 Inflation

Core minus shelter inflation appears to have bottomed out.  We have three straight months of C-S inflation at 0.1% or higher for the first time since 2Q 2014 and March C-S inflation came in at 0.2%, which is the highest reading for a single month in more than 2 years.

Shelter inflation for the month was 0.27%, which is about the trend level we have seen since the mid 1990s, except for the aftermath of the 2008 crisis, where the drop in incomes became sharp enough to cut into housing consumption.  I attribute this to a long-running shortage in housing, which was only partially mitigated during the housing boom of the 2000s.

The post QE mortgage recovery story continues to look plausible.  One danger was that non-shelter inflation would continue to fall, and that the economy wouldn't have the legs to keep recovering without QE.  I think the economy is close enough to systemic recovery now that real interest rates and real wage growth should be strong enough to allow for non-distorted economic activity even if inflation is somewhat soft.  The danger was mainly in sharp deflation.  It looks like we have avoided this.  Forward inflation expectations appear to have stabilized, also.

If mortgages begin to expand, we should see a convergence of shelter inflation and non-shelter inflation.  (This convergence will probably be associated with rising home prices, which will be erroneously associated with housing inflation.)  This happened from 2002 to 2005, also.  This should buoy real incomes and help keep the Fed from throttling liquidity, until the "bubble" police start begging for some more self flagellation.  As long as liquidity is made available, returns (and prices) of homes and real long term bonds should also converge to long term trends.

A commenter at The Money Illusion recently noted two articles from 2001 and 2002 that were already declaring a housing bubble.  The commenter meant this as evidence that there was a bubble and that it was something regulators could have foreseen.  Of course, anyone who bought a house in 2001 or 2002 would have done quite well, and would still be sitting on substantial capital gains.  From my perspective, those articles are evidence of how the bubble narrative was preordained as an explanation for any economic dislocation, well before the events of the boom and bust played out.

Those two articles (especially the second one) contain several common anti-finance shibboleths.  From the first article:
Supply is beginning to outstrip demand...(Robert) Shiller worries about an ominous mix of overdevelopment, inflated home prices and rising consumer debt.
From the second article:
(H)omeowners have every reason to keep their homes expensive. And, by coincidence or design, as home-equity finance has gained popularity, so too have no-growth movements, restrictive local zoning laws and other policies that constrain new-home construction.Demand soon outstrips supply. 
Both of these things, as any sophisticated observer will tell you, are products of some sort of conspiracy of some group of financial interests (builders, rich homeowners and investors, etc.) to keep pushing their "paper" profits up.  Paper profits, of course, being a sort of "Wall Street" demon pretender of the sort of incomes and gains that real people create.  We know that the economy is composed of (1) Wall Street power brokers whose machinations, even when they are direct contradictions of other supposed machinations, push prices to and fro, for the sole benefit of financial insiders and "the rich" and (2) helpless rubes who, as a group, chase bubbles, like addicts, in a fruitless attempt to escape their ever-descending economic state.  These things, we know, a priori.

The red team/blue team drama has latched on to these notions, which are firmly rooted in banal cognitive biases, because it allows for much more predictable arguments about cause.  If our understanding of outcomes is allowed to adjust for experience and empirical review, political debate will be complicated.  If we can all agree on unchanging, false premises, then we can get to the important work of arguing about whether the canard was the fault of Republicans or Democrats.  And, since most of these markets involve complicated tradeoffs, we can all agree on things, like, that rising home prices are lining the pockets of the 1% while they also simultaneously make it harder and harder for working families to afford a home.  Every transaction includes a buyer and a seller, which is sort of like magical pixie dust for populist rhetoric.

Only a naïf would suggest that prices are, you know, information about underlying economic fundamentals, or that reasonable people, upon witnessing a massive increase in prices among the most widely distributed middle class asset, might consider it a sign of a very healthy middle class.

....Anyway, I'm getting off track here.  As in the 2000s, where markets function, prices tend to get corralled into fairly efficient equilibriums, even when there is pretty widespread conscious irrationality.  So, as long as liquidity is somewhat reasonable, this convergence should be fairly inevitable.  But, since these irrationalities are expressed politically, there is a decent likelihood that we will see another dislocation eventually.  But, until that happens, the return to real estate should converge to the long term relationship with real bond returns, as shown in this graph.  (Bond returns were probably higher in the 1980s because nominal bond yields reflected an inflation uncertainty premium.  However, if that wasn't the case, then this long-term relationship would suggest that home prices were too high in the 1980s and 1990s and were normal in the 2000s.  I don't think anyone argues that.)

Bond and home prices are about 2% away from their widest typical relative returns.

As mortgages expand, home prices should rise, creating a sort of virtuous cycle of liquidity creation.  Forward inflation expectations of about 2.5%, with real long term interest rates around 1.5% (nominal rates of 4%) would equate to real estate yields of about 3% - 3.5%, which would be associated with a decent rise in nominal home prices.

Weekly readings in the Fed's H.8 report on bank assets can be a bit noisy, but this week's numbers seem to confirm a new growth rate that is kicking up toward 1% per month.  This graph shows Closed End Real Estate Loans outstanding, both seasonally adjusted and not adjusted.

There is a monthly cycle with these loans, and the March to April comparisons have been strong.  All in all, I'd say today's reports are tentatively good news.

Wednesday, April 15, 2015

Institutions, individuals, and American Politics (aka: Progressivism becomes Conservatism)

Recently, Chris Rock said:
I stopped playing colleges, and the reason is because they’re way too conservative.
How can this statement make sense?  Here is a simple way of imagining US politics.  I included a version of this, in my post on jubilee.
This could use less loaded language.  High respect here  means being careful
about changing or controlling something.  Low respect means being more
willing to change or control something.

Let's begin with conservatism.  It is kind of the core of the natural state of human community, which was surely made possible by our biological tendency to strongly favor our tribe, our tribe's leaders, and our tribe's idiosyncrasies.  Loyalty to our received institutions is the core value here.  There's a place for that value.  There is real value in the Burkean sense of trepidation about changing institutions.  Capitalism creates a constant stream of challenges to status quo arrangements.  But, the American Constitution, one of our received institutional foundations, is the cornerstone of American liberalism and capitalism, so American conservatives are in the awkward position of defending the very system that inevitably speeds adaptive changes in status quo moral norms.  This is probably one of the lucky accidents of the modern West.

Libertarians tend to have some affiliation with conservatives in the U.S.  I think that this is because libertarians share a respect for our liberal Constitution.  But, where conservatives emphasize the duty of individuals to serve institutions, libertarians see the value of institutions as a product of how they serve individuals.  Libertarians can be protective of the Constitution or religious institutions, but are more likely to view them from a Hayekian perspective - that these institutions are emergent human creations.  Whether it is the law, the market, or religion, we may see imperfections and sources of unfairness, but with emergent systems, we must be wary of the uncountable number of interactions and relationships that escape our limited observations.  Just as we wouldn't want to roll through the rainforest, say, killing all the large predators, libertarians are wary of popular proposals aimed at broadly manipulating public behaviors and outcomes, because of possible unintended and unseen consequences.  Libertarians are Burkean liberals, and they defend emergent order, in the form of markets and free society, and core institutions that promote their peaceful incubation.

Moving around the circle, liberals are much like libertarians, but with less trepidation about changing institutions.  From conservatives' point of view, liberals frequently seem anti-American, or anti-religious.  That is because it is important to liberals that their institutions - institutions that they have control over and that have control over them - are just, and they are not hesitant about calling out their own institutions when they disagree with them.  This is also a product of the modern West - a sense that we aren't just custodians of received institutions, but that we are responsible for correcting our institutions when they are in error.  Libertarians and liberals each generally value both limited government and democracy, but liberals tend to favor democracy where libertarians favor limited government.  For liberals, democracy represents the power to perfect our institutions.  The Bill of Rights might be the best American example of liberalism, with the 1960's Civil Rights battle as its most recent apex.  And, when liberalism triumphs, in hindsight, it is usually a universal triumph.  The Renaissance, the Reformation, the Enlightenment, and the Industrial Revolution describe a multi-century process of the triumph of individuals over institutions.- the triumph of broad progress over imposed status hierarchies.

Moving from liberal to progressive, we move from a sense of perfecting institutions to serve individuals toward a sense of perfecting institutions to perfect individuals.  Where conservatives would press others into a world that once was, progressives would press others into a world that never was.  Where liberals would mold existing institutions to make people free, progressives would mold existing institutions to make people behave.  Here, we have another accident of history.  The Civil Rights advancements of the 1960's were a great liberal victory.  But, we can divide those advancements into two categories.  The more libertarian victories were changes that reduced governmentally imposed discrimination.  These were changes that allowed institutions to better serve individuals.  The more progressive victories were changes that imposed rules on private citizens.  Even though the core victories were libertarian victories, the progressive changes became a part of the package of changes we identify with the Civil Rights era, and libertarian opposition to those elements meant that progressives took the mantle as heirs to Civil Rights liberalism.

I say this is an accident of history, because progressivism is decidedly illiberal.  As with all of these political conceptions, there is a core of virtue here.  The progressive core is a sense of justice - of righting past wrongs.  We need this, just as we need the sensibilities held dear by the other wings of political ideology.  This sense of justice - of fighting oppressors - leads to categorizations.  Rich vs. poor.  Majority vs. minority.  Men vs. women.  Employer vs. employee.  These categories can become the core principle itself.  Progressive policy positions are usually a reflection of the need to rebalance power among these groups.  Where liberalism demanded individualist equality under the law, progressivism applies the law based on group identity.  Progressive policies are usually associated with positive liberties.  In commercial contexts, this usually means that employers and capitalists are coerced for the presumed benefit of employees and consumers, through redistribution, progressive taxation, and a host of norms imposed selectively on private for-profit firms, such as workplace and wage restrictions and anti-discrimination rules.  Positive liberties generally, in practice, equate to the selective denial of negative liberties.

So, while this is rooted in a quest for justice, in practice it is essentially ad hominem.  This article is a case in point:  "Wal-Mart’s new scheme to prey on America’s poor".  Note that the article makes no attempt to even create a poorly constructed straw man set of expectations.  Wal-Mart is creating valuable banking services for poor people, which is bad...because it's Wal-Mart.  There is a movement to create low income banking services through the Post Office.  The movement must insist on preventing Wal-Mart from establishing banking services and must implement them politically through the Post Office, because the Post Office represents control.  Imagine if both the Post Office and Wal-Mart start offering banking services.  Where do you imagine most poor people will choose to bank?

The attempt at egalitarianism and at leveling social injustices arises from a virtuous sense of justice.  But, in practice these ideas serve as a sort of original sin - a problem that can never be rectified - and thus morph into a permanent lineup of favored and disfavored groups.  The writings of Robert Reich, Paul Krugman, etc. are infused with these explicit appeals to ad hominem. They talk about "The rich" or "corporations" or "Wall Street" as a monolith, with rhetorical tactics that would be clearly offensive if directed at an ethnic group or race.  The message is "They're different than you and me".  Progressives become modern Pharisees.  Advocacy, OWS marches, and Facebook status updates are like loud public prayers at the temple.  Corporations and investors are perpetually unclean in the eyes of the unbending law of egalitarianism.

Progressives oppose Citizens United*, for instance, in spite of liberal principles regarding political speech, explicitly because some of the plaintiffs are associations formed to facilitate shared ownership of productive capital.  Corporations own capital - a progressive original sin.  If your core principle is that rights should be enforced selectively to counter power, and capital represents power, then "getting money out of politics" seems principled.  But, really, there are any number of sources of political power - all of them distributed unequally.  Progressives are simply singling out the one source of power that is associated with their chosen out-group and selectively attempting to remove it from the realm of protected rights.  There is no principled difference between this position and, say, preventing gay couples from marrying or keeping minorities out of good schools or limiting property rights for women.  Progressives will argue that selective treatment is warranted here, as a way to correct for power imbalances.  But all sectarians think they have their own good reasons for selective treatment.  Progressives are applying conservative (or, more precisely, sectarian) principles.  They have simply changed who's in and who's out.**

Thus, progressivism in power is crude conservatism.  There doesn't seem to be an ideological mechanism for progressivism to transmute into conservatism, as there was from conservatism through libertarianism and liberalism.  The mechanism is power.  In power, progressivism becomes conservatism, but not the conservatism that we are accustomed to, which at least defends our received liberal foundations.  It is a pre-liberal conservatism, explicit in its insider-outsider identity-based favoritism, and decidedly anti-bourgeois.

* I am endlessly amused by the fact that opponents to Citizens United, who generally use slogans, such as, "Money is not speech, and human beings, not corporations, are persons entitled to constitutional rights." fight this ruling by forming corporations, associations, and affiliations, and with a united voice making public statements of conscience.  Here is a petition that implores boards of trustees, congregations, and committees to demand that "corporations aren't persons and money is not speech" and ends with "This work is made possible by the generosity of individual donors and congregations."  Clearly, these groups are engaged in reducing the rights and status of commercial producers.  I am curious about the motivations that cause them to avoid language that would make this more clear in their petitions.  This disconnection does not come from a shallow or conscious place.

**  Of course, I'm being unfair to conservatism here.  Prejudice is sometimes a kind of a side effect of conservative biases.  Progressivism has made a prejudicial viewpoint a core principle.  Think of how frequently the progressive media will simply note that something good happened to the rich, or whites, or corporations, or men, and this is understood to be bad news.  If we think in progressive terms, we can see how there is some base virtue at work here - a desire to pull outcomes toward a mean.  But, if we think about this in terms of avoiding a corrosive mindset, it's really quite nasty.  With any prejudiced point of view, our biases start to inform our interpretation of the world and our acceptance of perceived facts.  If prejudice is a central virtue, how in the world can you expect to interpret facts with a remotely objective perspective, especially if you are surrounded by like minded ideological partners.  Think of how biased and ill-informed people generally are who openly espouse white supremacy, misogyny, and nativism.  Accepting that progressive prejudices are ground in a sense of justice, still, why would we expect them to be any more reasonable or informed than unjust prejudices?  Even the wise Benjamin Franklin famously wrote a friend about German immigrants, "…Not being used to Liberty, they know not how to make a modest use of it; and as Kolbern says of the young Hotttentots, that they are not esteemed men till they have shewn their manhood by beating their mothers, so they seem to think themselves not free, till they feel their liberty in abusing and insulting their Teachers…."  And, he didn't consider it a virtue to dislike Germans.  This mistake was by accident because he was kind of put off by them.  Imagine how ignorant he would have been if he considered being anti-German to be a morally uplifting core principle.

Being a financial nerd around progressives is, I suspect, like being an evolutionary biologist around creationists.  Creationists would constantly be talking about your favorite subject.  You might at first think, "Oh! Yeah!  Seemingly irreducible complexity!  What a fascinating topic.  How could these mechanisms evolve?"  But, you would soon find that their interest in the topic is to specifically not learn those things.  Such is the case with progressives and inequality, or the balance between wages, interest, and profits, or markets in general.  Progressive approaches to economic and social matters are informed by the goal of pulling down the status of commercial associations.  This does not lend itself to objective review of stochastic statistical information that moves around a tentatively stationary mean.

Take an issue like income inequality - a favorite issue today.  To the extent that it is an interesting subject - which it seems to be to many people - it is the product of a complex web of causes, such as the revolutionary global explosion of the internet and digital technology, the empowerment and education of women, the extension of education and retirement in our lifecycles, changing household composition and size, the new trend of lower income being associated with more leisure, etc.  Yet almost all of the discussion revolves around factional political issues like tax rates, which probably are a small part of the story, or growing corporate profits, which is empirically incorrect.

The reaction to much economic progress makes me think of this scene from Seinfeld.  (George is basically demanding that any change in his dating life is a Pareto improvement.) Whenever I hear something about foreigners or robots or some other source of new productivity taking everyone's jobs, I want to ask, "Do you want to be able to get your hand out of her hair, or do you not want to be able to get it out?":

  I think you'll get it out.

Tuesday, April 14, 2015

Housing Tax Policy, A Series: Part 26 - Rent Inflation as a Signal of Supply and Demand

There is the problem in macro data of considering the effect of inflation on different types of households.  We tend to discount nominal income numbers with national inflation measures, but over long periods of time, we really don't have a good idea of how cost of living has changed for different households.  Depending on geography, socio-economic status, etc. the effect of individualized cost of living adjustments might even dwarf the kinds of trends in incomes that dominate public discourse.  I was reminded of this recently when I was looking at rent inflation statistics.  Rent for housing amounts to about 30% of the component weights in the CPI.  And, this category is specifically divided between home owners (Owner Equivalent Rent for Primary Residence - about 23%) and renters (Rent for Primary Residence - about 7%).

So, for renters, 23% of the CPI is, by definition, a cost that is entirely missing from their actual basket of goods and services.  Now, over time, housing supply for owners and rents does have some marginal substitutability, so they have some relationship.  But, they can diverge quite a bit.  Owner rent inflation cumulatively moved higher than renter inflation by nearly 10% in the late 1990s, but renter inflation has caught up with it since then.

I think the difference between these inflation categories can be meaningful in my eventual analysis of tax policy's effects on home prices.  There are types of housing that are more amenable to renting, usually multi-unit structures.  These generally have more community areas and less privacy, which act as a natural mitigation to the principal-agent problems that arise from having a tenant who is not the owner.  The close neighbors and property managers help regulate the tenant/owner relationship.

For home owners transitioning from renter to owner, ownership itself adds value to the property by eliminating these principal-agent problems, and this added value is maximized by owning a separate, private residence that isn't regulated by close neighbors and managers.

Obviously, on the margin, there are counterexamples.  A small portion of the real estate market consists of condominiums.  And, many neighborhoods try to capture some benefits of communal regulation through Homeowners' Associations.  But, for our purposes in this analysis, the fact that the owner and renter market are highly segmented is useful.

Looking at the difference between owner and renter inflation, we see a sustained rise in owner inflation from the mid 1980s to the mid 1990s.  This coincides with the new importance of the mortgage interest deduction in 1986.  So, we can think of this as a signal of added demand in the homeowner market, as households moved to capture the added after-tax value of owning a leveraged home.  We would look to see how much of an increase in homeownership there was, and estimate the added consumer surplus captured by homeowners.

But, surprisingly, during this period, there was no rise in the rate of homeownership.  We need to think about the effects of the mortgage tax deduction carefully.  As this paper notes, and I discussed here, the mortgage interest tax deduction is overwhelmingly captured by high income households.  In fact, real estate leverage tends to increase with income.  So, this tax benefit went overwhelmingly to households who already had pretty universal homeownership rates among households who wanted to be homeowners.  So, the effect of the mortgage interest deduction is pretty simple.  The entire benefit went to owners.

If there had been an increase in ownership, we would need to estimate what marginally extra dollar of after tax value enticed each marginal renter into ownership.  If the tax benefit added 5% to the nominal value of a property, it may be that renting was worth 4.9% more to the individual, and so a 5% increase in owner-occupied housing consumption would only represent a 0.1% increase in utility for the household.  But since ownership was flat, we can estimate the gain to homeowners with the rise in owner-occupied housing consumption.

The benefit had two effects.  The demand for homes by owners shifted to the right, because home consumption was now relatively less expensive, after taxes, than other forms of consumption.  This increased real housing consumption.  But, to the extent that there are limits and costs to the availability of housing, because of the scarcity of land and materials, regulatory limits, etc. some of this extra demand will show up as inflation, specific to owned properties.  That shift upward in owner consumption would also be associated with a decline in renter consumption to the extent that there is competition for supply between the two markets That is what we see in the graph above for the decade after the mid 1980s.

This chart suggests that amounts to more than 1% of GDP.  The Wharton paper mentioned above puts it at about 1% of GDP in 2003.

The value of the non-taxability of imputed rent is a much larger value.  (The Wharton paper estimates it to be nearly twice the value of the mortgage subsidy.)  This would explain why the mortgage interest deduction didn't move homeownership higher.  There were already such large tax advantages to ownership that any household that valued ownership at all (and even some who would have preferred renting in a tax neutral context) were already homeowners.

So, while this increases the possible effect of the mortgage tax deduction, compared to the estimates I used at the beginning of this series, the effect of the capital gains exemption on housing might be less than I thought.  As we can see in the first graph, this inflation signal goes away after the mid 1990s.  I think what has happened is that the capital gains tax rate on non-housing assets was reduced at about the same time that the exemption was strengthened in housing.  These may have had offsetting effects.

So, while there may be less of a capital gains exemption baked into current home values, this could suggest danger for future capital gains tax rate increases.  If capital gains tax rates are increased, it could lead to a new inflow of capital into housing which we avoided in the 1990s because of the tax rate reductions.

So, what did happen in the 1990s and 2000s?  One of the surprising details of Matthew Rognlie's recent work that I think has gone unnoticed is that, while it is true that the transfer of income from labor to capital has gone to housing capital, not to corporate capital, none of the gains to housing capital came during the housing boom.

As we can see in Rognlie's graph here, and in the following graph from one of my previous posts, from the mid-1990s to 2007 total capital income to housing was level, at best.  The gains to housing capital came before 1995 and after 2007.

I have explained how the pre-1995 gains might have come from the inducement from the mortgage tax deduction for homeowners to increase their nominal consumption.  The gains after 2007 are clearly excess gains from limited access.  Homeowners are earning excess returns because supply is limited by the hobbled mortgage market.

So, the boom of the late 1990s and 2000s wasn't a product of new demand from homeowners.  Nominal home values were being pushed up by outside forces (manifest in low real long term interest rates, mainly). This is corroborated by the fact that owner inflation was not high during that time, and owner consumption (gross rent) leveled off after 2000.

As I have argued previously, the sharp rise in nominal home values, and frictions in the housing market made house prices sticky and kept supply from rising enough to meet demand. So, interest rates were pushing up Price/Rent ratios, and the lack of supply was pushing up rents for both renters and owners.  The flippers and speculators weren't creating a bubble, they were just capturing the arbitrage profits of sticky prices (which is a more reasonable description of typical speculator behavior across markets to begin with).

This is mistitled.  Home prices are not included in the graph.
Here is a comparison of shelter inflation with Core CPI, which removes some of the food and energy noise out of the comparison.  Notice that after a period of shelter inflation from 1985 to 1988, there isn't any net excess shelter inflation until the mid 1990s.  This suggests that, even though households weren't switching from renting to owning, there was a gradual shift among homeowners to consume more housing while renters shifted to consume less, because of the unbalanced effect of the new tax subsidy on demand that favored owners and caused prices to rise in properties held by owner-occupiers relative to rented properties.

Homeownership started climbing in 1995, which seems to be related to policies like the evolving Community Reinvestment Act.  This might have led to some of the higher owner inflation that persisted until about 1997 (in the first graph above).  But, after that, shelter inflation in general continued to run high, but not particularly for owners.

I have come to the opinion that the CRA was a largely beneficial policy.  It looks to me like it moved several million middle-to-upper-middle class households into homeownership who were previously held out of the market for home ownership for reasons other than price.  That is all for the good.  The fact that much of the increase in the homeownership rate increase happened before nominal home prices began to rise and much of it happened without leading to owner-specific rent inflation suggests to me that these marginal new owners weren't pushing up the Price/Rent ratio on homes.  They were consuming homes as owners instead of renters, so there was some decline in renter expenditures and an increase in owner expenditures, in terms of Gross Rents / GDP.  And, there was some total increase in Gross Rents/GDP because access to home ownership was allowing these households to capture the gains from eliminating the principal-agent problem that exists in rented residence.  But, the intrinsic Price/Rent value of the homes these households were buying wasn't any higher than it had been for existing homeowners, so this movement into homeownership didn't, itself, lead to rising implicit rents and home prices.

All of this suggests that, outside of the immediate aftermath of the GDP collapse in 2008, there has generally been a shortage of housing, first from the inability of prices to adjust in the face of falling long term real interest rates, and second from the collapse of mortgage funding.

I have previously been somewhat muted in my expectations for housing starts going forward, because of widely known demographic trends, but there could be a large amount of unnoticed housing demand that has been waiting for 20 years to be supplied.  The recovery for homebuilders, if the banks are allowed to fund it without everyone crapping themselves about it, could be much higher than the current marginal expectation.

Further, if the 10% cumulative rise of owner inflation over renter inflation in the late 1980s represents the tax arbitrage value of the mortgage tax deduction, then we should expect a further 10% recovery in owner-occupier home prices above the prices of renter-occupied homes, if mortgage markets are allowed to begin to fund growing levels of home purchases again.

PS.  I suspect that there are many errors here, as this is quite complicated.  If you know of a technical correction that should be made, please note it in the comments.  That is your fee for having read it, accepted by the author on the honor system, as a free will offering.  If you gained negative utility from reading this, however, please do me a favor and refrain from giving bad advice in the comments in retaliation.  I am resigned to your goodwill.

Friday, April 10, 2015

Odds & Ends and IMH

This Wall Street Journal article (HT: Benjamin Cole at Historinhas) is like a chapter out of Gulliver's Travels.  I mean, literally, you could stick this scene on a floating island, and paste it into the book, word for word.  It's full of stuff like this:
The Treasury Department’s report to Congress on the exchange-rate policies of major trading partners called on policy makers “to use the full set of policy tools at their disposal.”
“Not only has global growth failed to accelerate, but there is worry that the composition of global output is increasingly unbalanced,” it said. “The global economy should not again rely on the U.S. to be the only engine of demand.”
Not since the last semi-annual currency report has so much "reasoning from a price change" been used to say so little with such authority.  Some observers believe that central banks don't have that much influence over inflation.  I disagree with that.  But, I can see how it could seem true, or be true.  We could give Treasury officials and central bank officials around the world big computer terminals with a lot of buttons and levers, but not connect them to anything, just have random colors and numbers flash on the screen as they pull and push on them.  Then we could occasionally tell them what a great job they are doing, or chastise them for pulling too many levers.  It wouldn't look much different than the world we have today.  What's the difference between trying to describe a web of exchanges we can't begin to understand and just making stuff up?

The first line of the article:
The Obama administration chastised Europe and Japan for excessive reliance on monetary policy to revive stagnant growth....
This seems like strong form IMH.

Maybe Office Space is a better place for this scene than Gulliver's Travels.

"Um...Yeah...So, Germany, we're going to need you to work over the weekend to get those TPS reports in.  M'kay?"

On the topic of EMH and IMH, here is a Harvard Business Review article that discusses recent research that shows inside information can lead to worse decisions.  This doesn't surprise me.  I have always thought that the difference between weak form efficient markets and strong form efficient markets was less stark than it is generally perceived.

We tend to think in terms of clear episodes, like a bio-tech firm getting FDA approval for a new drug, or something like that.  But, the vast, vast majority of investment information and decisions are bathed in a complex set of factors that make simple information very difficult to value in isolation.  Insiders are frequently very poor traders.

Financial speculation depends greatly on discipline and perspective.  And the denominator in the valuation of perpetual streams of cash flows is very important, even while it is wholly unknowable.  If you haven't honed those things carefully, gaining new information can very easily lead you to give more weight to incorrect perceptions.

I used to think this was limited to the nooks and crannies of the investment space - little microcaps that just didn't get enough attention for markets to work out efficient expectations.  But, even in something as big as the money supply and the housing market, it is interesting how if one begins in 2006 with two very different ideas about what is happening (a "bubble" where prices are unrelated to underlying value vs. a rise in nominal intrinsic values coming from high demand for low risk savings vehicles as a hedge against a quickly evolving global economy), then practically all of the new information one would have seen since then (assisted by ever-present confirmation bias) would seem to serve to confirm your narrative.  You would become more confident in either narrative as time passes.

One of Robin Hanson's general themes is that we have a biological predisposition to be sincerely the most confident about things that are the most incorrect, if we are socially primed to believe them.  So, the good news is that it isn't such a disadvantage to lack inside information.  The bad news is that we are all equipped with our own very powerful miscalculator.

Tuesday, April 7, 2015

The Treasury/Housing trade

I may be jumping the gun a little bit, but I think it looks like it is time to take a position on the treasuries/housing trade.  My thesis is that there is a large disequilibrium in the fixed income market.  Implied returns on houses and cyclically adjusted very long term real interest rates generally rose and fell together until 2007, when tight monetary policy caused a collapse in the housing credit market.  Since then, fixed income savings has been forced into treasuries, because of a lack of access to the real estate market, due to a stagnant mortgage market and market frictions that prevent investors from immediately making up for the lack of owner-occupiers in the single family home market.  The drop in total real estate holdings below trend is much more severe than any movement in the 2000s above trend.

A recovery in the mortgage market should allow savings to flow more readily into housing.  This should allow treasuries and residential real estate to coalesce back at an equilibrium relationship.  This means that home values should rise and treasury yields should also rise.

I don't know where the new balance will be.  This is not a hedged position.  If the economy falters before recovery is established, both of these positions will fail.  I don't believe that the policy interest rate is the bottleneck to the productive economy right now, though.  I believe mortgage credit is.  As long as the banks continue to expand mortgage credit, I believe the Fed would need to raise rates significantly in order to damage the coming recovery.  The key is expanding mortgages.

The point of taking the dual position (long housing, short treasuries) is so that I don't need to know the balance.  If long term real interest rates don't rise very much, the gains from this position will come mostly from the housing position.  If long term real interest rates rise more, then home prices will rise less, but the short treasury position will gain.

Mortgage growth appears to just be beginning at commercial banks.  Forward risk free interest rates have pulled back to new lows.  And, the employment market continues to look strong.  Job openings and quits continue to grow, even though hiring has leveled off in the past few months.  And, employment flows all continue to normalize, with strong flows back into the labor force.

Along with the new rise in mortgage levels, it looks like home price growth might be starting to move again.  I am counting on this new kink up in price appreciation to be persistent.

There might be several ways to capture exposure to residential housing.  I am not sure if any are better than taking an out-of-the-money option position on marginal, leveraged homebuilders.  Possibly the Case-Shiller Index would be a way.  And, there are many REITS of various types to choose from.

Note that unlike some economics bloggers, I am frequently devastatingly wrong.  Mileage may vary.

Thursday, April 2, 2015

Housing Tax Policy, A Series: Part 25 - Human Capital and Low Risk Assets

Following up on yesterday's post, I would like to ponder how the blossoming of human capital plays out in modern capital markets.

If the expansion of home values is a product of an expanding pool of human capital, then this suggests that the growth of capital in this area isn't coming at the expense of other forms of physical capital and it isn't due to a surplus of capital.  This is simply a transfer of capital from a form of capital that wasn't being measured (human capital) to a form of capital that is measured (home equity and mortgages).

In addition to this issue, we also have the issue of international capital flows, which Ben Bernanke discussed recently at his new blog.

In addition to the human capital issue, developing market economies are also creating new demand for low risk investments.  Capital holders in those economies previously earned rents through limited access.  As those economies have liberalized and joined the global economy, they have entered a transitory period, where capital is expanding strongly, but risk is still considered high, and elites cannot capture the rents that they had when the economies were more closed.  So, these economies are producing a tremendous amount of new capital, much of which is reinvested in local, at-risk productive ventures.  But, there is a demand for low risk investments, and those economies have not developed trust and institutions to supply it.

So, there is a large amount of emerging market capital looking for low risk outlets in the developed world.  Bernanke's post includes a table of current account balances, which essentially shows a flow of capital into the anglosphere.  This spiked to an incredibly high level in the US in 2006, then fell back again to the level seen in 2000.  Canada, Australia, and the UK have continued to see high or increasing capital flows.  Some of the decrease in capital inflows to the US is surely related to new oil and gas production, which has reduced our need for foreign fossil fuels.  But, I think it is interesting to note that all of the other anglosphere countries had a housing boom, but none of them had a housing bust.

I suspect that if we can manage to allow our housing and mortgage markets to fully recover, some of the decline in our trade deficits that has seemed to have come from the US petro-boom, may actually reverse, as foreign investors find access to US real estate more accessible.

I don't think there is anything unsustainable about this.  US corporations are investing in at-risk, high return operations overseas, and foreign capital holders are investing in safe, low return securities in the US.  This is a symbiotic relationship.  Foreign capital enjoys a risk profile that matches its needs and US capital owners earn profit by taking on that risk.  This essentially funds our trade deficit while foreign capital continues to pour into the US.

So, there is not so much a glut of capital as there is a transfer of capital between foreign and domestic and between human and physical.  This makes sense to me.  Interest rates on treasuries are usually treated as the measure of returns to capital, but I think this is misleading.  I have described what I think is a better way to think of required returns to capital.  Instead of thinking in terms of returns to risk-free debt, and adding an equity premium on top of that, I think it may make more sense to begin with a total return to unleveraged at-risk capital, and consider interest rates on debt to reflect a transaction between equity holders and debt holders about how to share those returns.  The equity premium, in that framing, is more of a discount accepted by debt holders to avoid volatility in cash flows.

The reason I think this is a better framing is because total required returns to corporate capital are pretty stable over time.  Whatever cultural and economic factors create an expectation of returns for putting capital to work in productive enterprises, they seem to be pretty stable and unrelated to the discount that debt holders are willing to accept for cash flow stability.

The first graph to the right is an estimate of required returns to the S&P 500.  The second graph is a similar estimate for all nonfinancial corporations.  (In both cases, I have simply used the GDP deflator to adjust from nominal bond yields to real yields, so part of the dip in the 1970s and the rise in the 1980s likely comes from the fact that inflation expectations lagged actual inflation.  In either case, the recent drop in real risk free yields is not associated with a drop in total required real returns.)

As I have outlined in my housing series, the implied returns to housing from rent tend to move over time along with long term real interest rates.  So, we have 4 major asset classes. (1 & 2)  Treasuries and corporate debt, which have yields that are somewhat related, and whose outstanding value does not particularly respond to demand by moving inversely to yields. (3) Real estate (equity and mortgage), which have yields that tend to move with other debt, and whose total value does rise and fall with real yields (inversely). And (4) corporate equity, which has "yields" that are fairly stable and value that is very volatile through the business cycle, but relatively stable over time.

So, the capital inflows coming from the conversion of human capital and from the inflow of foreign capital only have two outlets, on net.  One outlet is in an expanding real estate market, and the other outlet, in an open economy, is the expansion of corporate assets into foreign markets.  If there was some surplus of capital searching for yield, then shouldn't we expect all yields to fall, including corporate assets (equities)?  Instead, we are simply seeing the transfer and trading of different forms of capital - foreign and domestic, human and physical.  So, the total returns to corporate capital are stable because there isn't any particular change in the supply and demand of total at-risk capital.  There is just an expansion of US corporate capital into foreign markets as part of the trade with foreign capital that is bidding up the discount on US debt.  And there is an expansion of anglosphere real estate, reflecting both foreign capital and the time arbitrage of human capital.  Both of the capital inflows (foreign and human) push down the risk free rate (or stated differently, push up the discount from total required returns on at-risk capital), but total returns to corporate equity remain fairly stable, even if they need to search abroad for those returns.

There is no unsustainable imbalance in international capital flows.  And, I doubt if low real interest rates reflect any great stagnation, beyond some changes in production growth coming from fluctuations in the working population.  Stable total returns to corporate assets suggest that we don't have secular stagnation.  Low risk free interest rates are related to the foreign capital trade and diversification of human capital, which are both products of a productive, growing, and hopeful world economy.

PS: I neglected to mention in yesterday's post the thought I had first had in one of the inequality posts that I linked to yesterday.  It so happens that we do have some housing taxation policies that might make sense in this human capital framework.  If we think of redistribution in terms of the illiquidity of human capital, we would want to subsidize the formation of human capital.  But, since outcomes of human capital can't be diversified, and are highly variable, we would want to tax earned human capital.

There are four main tax policies in home ownership. (1) Property taxes, (2) mortgage tax deduction, (3) capital gains exemptions, and (4) nontaxability of imputed rent.

In yesterday's post, I described mortgages as a shadow of future expected returns to human capital.  The Mortgage tax deduction is a subsidy of expected future human capital.  So, in this framework of thinking about housing and human capital, the mortgage tax deduction would encourage the development of future human capital.

I described home equity as a shadow of earned human capital.  Property taxes, then, are a tax on earned human capital.

The combination of high property taxes and a mortgage tax deduction would create a sort of public diversification of human capital by redistributing gains away from those who are fortunate enough to have had high returns to human capital.

The capital gains exemption and nontaxability of imputed rent are large subsidies to home equity, so these are highly regressive policies, giving even higher gains to those who won the human capital lottery (receiving higher returns than they had expected).  These would most effectively be eliminated by eliminating corporate and capital taxes.  Since some arguably large portion of those taxes do not fall on the capital owners themselves, but are passed on proportionately to workers and consumers as prices and required returns equilibrate, the elimination of these taxes would eliminate these highly regressive real estate tax subsidies with little or no downside, even before factoring in international tax competitiveness.

Wednesday, April 1, 2015

Housing Tax Policy, A Series: Part 24 - Housing: A Trade in Human Capital

In the comments, Joe Leider points to this economist article and Chuck E. points to this article.  Both articles are discussing this paper (pdf) from Matthew Rognlie at MIT that is a response to Picketty's recent work.

One of the points he makes is that the growing share of income going to capital has been going to homeowners, not to corporate owners.  Here is a graph from Chuck's article.

I made the same point in this series of three posts.  Rognlie obviously tackles the issue with much more depth and quantitative analysis.

Here is a recent post where I looked at capital allocations and incomes.  Here are two posts where I addressed the issue of housing and Picketty.

Sorry for all the self-references, but I've been kicking around these ideas about the interplay between corporate capital, housing capital, and human capital.  Maybe I'm repeating myself, but I think there is an interesting long-term issue to consider here.

I was trying to excerpt from the two posts in reaction to Picketty, but I'm finding it difficult.  I normally don't do this, but I think I need to introduce these two posts, in their entirety, as a preface to this post.  If you are put off by the intemperate post titles, please forgive me.  I think you may find something edifying there if you read them both to the end in spite of my rhetorical excesses.

The Absurdity of Blaming Capitalism for Inequality - Part 2
The Absurdity of Blaming Capitalism for Inequality - Part 4

This current series of posts, which has busted through the cattle gates around the original topic I was considering, started as a sort of work in progress to estimate the effect of tax policies on incomes and home prices.  I haven't finished that yet because of all the tangents like this one.  But, an interesting issue, highlighted by Rognlie, is that there has been a significant increase in housing consumption, across nations and across time.  There is a lot going on here outside of tax policy.

In the two posts highlighted above, I play with the idea that the defining character of this era, the dark matter of economics, is human capital.  Even much of what ends up as traded capital in the tech. economy comes from human capital.  The ownership stakes of Silicon Valley founders and early stage employees are not the product of capital investments as we normally think of them.  They are the product of highly variable outcomes resulting from serendipity, skill, innovation, and coordination - explosions of human capital in a world that is still in the adolescence of a technological revolution.

Human capital has the problem of being very illiquid.  Human capital development is constrained by individual idiosyncrasies and cannot be easily diversified.  This is the source of much of the current variability in wealth and income.  The disappointing thing about the debates that came out of Picketty's work is that they seem to be focused on returns to physical capital.  This makes for a much more politically predictable framing of the debate at the expense of missing the truth of the matter.  There isn't a constituency out there dying to hear that taxing education might mitigate inequality more effectively than taxing corporate earnings.

So, in some ways, human capital today carries some of the characteristics of pre-industrial capital, where landed elites captured very high profits, but were tied to their property.  But, today's human capital comes from a much less stable context.  While the earnings of a given individual may be inherited, the capital itself cannot be handed down through generations.  So, we all fumble our way through our productive lives, and every once in a while - Shazam! - a Jeff Bezos combines tremendous skill, hard work, cooperation, and serendipity, and suddenly owns a massive expanse of digital real estate.

Jeff Bezos is an outlier, although these outliers, together, are a good part of the vaguely unpopular 1%.  But, across the economy, for every Jeff Bezos, there are a hundred thousand engineers, computer programmers, middle managers, etc. who are playing smaller roles in this same drama.  We are the sole owners of the collected value of our individual experiences, training, and skill.  There is limited potential to diversify and share this value, which is a shame, because, as with modern public corporations, this would add real value.  We would be wealthier for it.  In fact, some forms of income redistribution could be seen as a sort of planned diversification of human capital.  In that way, some forms of redistribution or access to skill development could be seen as public goods - providing added aggregate value by reducing the discount rate applied to the future returns from human capital.  For those not used to thinking this way, this might seem like financial hocus-pocus.  But, just as with publicly traded corporations, this represents real value.  The liquidity premium is, in the end, tangible.

One way in which human capital can be traded is through real estate transactions.  In the "Part 2" link above, I show a brief outline of how the value of human capital might look over the course of a single life.  The conventions we have around real estate ownership create a sort of arbitrage opportunity with our future selves.  We might think of the mortgage banker as an intermediary between our current and future selves.  When we purchase a home, the home happens to provide a stable source of collateral on which to build the transaction.  (This is the problem with student loans.  They are also an arbitrage with our expected future human capital, but since students lack the ability to take a token position in a stable piece of collateral, the transaction cannot be established.)  The use of nominal, amortized debt to buy the house is basically a way in which the home buyer can contract her future returns on human capital to her current self.

The mortgage is, in effect, a measure of some portion of unrealized human capital gains, and home equity grows out of a combination of realized human capital gains and realized capital gains on the real estate itself.

In these ways, human capital is transformed into both "physical" capital (although much of this is in the form on intangible corporate assets or market values) and real estate capital.

So far, I have mostly been repeating myself, and I have probably gone on too long.  But, I think there may be additional ramifications here.  Jeff Bezos has a way to diversify the unrealized gains from his human capital.  He took it public, along with some other capital, under the ticker symbol AMZN.  Most of us don't have this option.

For most of us, the only viable outlet for diversifying our human capital is this real estate time arbitrage.  Diversification has real benefits.  Liquidity is wealth creation.  This means that housing adds value, not just as current consumption, but as a sort of holistic portfolio management.  So, the growth in the nominal value of housing stock might give us a window into the growing value of human capital.  And, within that gross value, we can think of mortgages as a window into the value of unearned future expected profits from human capital.

I have been discussing this, mainly as a comment on the idea of capital's share of income, and how this may be an important factor to consider.  But in addition to housing being a reflection of this human capital, I think there may be the additional issue of causation.  This value might be causing housing consumption to be inflated, relative to what we might otherwise see.  Households would bid up rents in the process of creating real estate assets that can serve this function.

Also, this large pool of capital that is high return/high risk, would move households to adjust the other portions of their capital holdings to include more low risk assets (treasuries, debt, and real estate).  We might think of someone who is the steward of the assets of a family that owns a valuable, privately held business.  Those types of investors, referred to in the finance biz as a Family Office, are notoriously risk averse.

In finance theory, one cannot expect to earn profits from non-diversified holdings.  But, that only applies to holdings that can be diversified.  Holdings that cannot be brought into the market basket of goods tend to earn a premium on the non-diversifiable profits.  As incomes rise, and education, skill, and serendipity become more important factors in lifetime incomes, households across the income spectrum are holding larger and larger proportions of this dark matter capital.  Our portfolios are brimming with this high return, high risk, non-diversifiable asset.  We need to diversify the rest of our portfolio (our physical capital and real estate) with low risk investments.  Possibly, as incomes move ever higher as productivity and innovation continue their upward march, we will inevitably demand low risk assets.  This means lower yields on treasuries, more houses, and higher price/rent ratios on those houses.

I think this may explain, particularly, the especially high home prices - both in rents and in price/rent ratios - in places like Silicon Valley.  That is ground zero in the explosion of human capital, both earned and unearned.  The high cost of housing in areas like Silicon Valley is frequently blamed on zoning restrictions.  But, I wonder if, to a certain extent, the localized inflation of rents and home prices is an inevitable result of this human capital time arbitrage.

Tuesday, March 31, 2015

Replies to Comments, pt. 1

Kenneth Duda asked me for some additional graphs and comparisons.  I think I've touched on some of them in recent posts.  I hope to keep looking at new ways to think about housing returns as I finish the series.  In the meantime, one graph I haven't done is the one Kenneth asked for with NGDP alongside delinquencies, home prices, etc.  I have added it here.  We can only wonder what NGDP level targeting would have done.  NGDP growth did collapse along with the other measures.  It is pretty easy to believe that, if NGDP hadn't collapsed, home prices would never have dropped more than 10% and delinquencies and unemployment would have remained under 5% or 6%.

I'm becoming cynical.  If that had been the counterfactual, the papers today would probably be complaining about how high house prices and the stock market are, and how economic stability is lining the pockets of the wealthy and connected.  Most people I talk to seem very satisfied about the drop in home prices, and are put off by their current recovery.  I suppose a firm NGDPLT rule would immunize the Fed from the mood of collective self-flagellation, but I still worry what other means we would resort to if we were politically determined to destroy nominal asset values.  On the other hand, I would expect NGDP level targeting to pull real interest rates up and equity premiums down, and that itself should cause home prices to moderate.  So, maybe NGDPLT would actually quell some of those concerns.

I should probably clarify my comments about home prices.  I don't care whether they are high or low.  I care that they reflect a functioning marketplace of assets where households have relatively open access to assets with efficient prices, relative to other assets.  It's important to a functioning, coherent economy with widespread opportunity.  Given current tax laws, etc., home prices are not efficient.  I would love to see tax laws changed, which would probably pull home values back to about where home prices are now.  That would be great.  But, giving tax breaks to households who have the means to access assets returning 4-5% in real returns when their efficient returns compared to other assets would be more like 2-3% is not functional.  This is the case because mortgage financing is the only widespread avenue we have to home ownership, and it's basically been shut down for nearly a decade.  I think there might be better pathways to home ownership than a highly leveraged mortgage, but given that's what we have, it is very distortionary to be stuck in this place where the market is not functioning.

Travis V also had a request.  I always start babbling on when I try to reply to these comments from Travis.  Travis, did I come close to coherence, or do you feel I left something, or everything, unaddressed?

Thursday, March 26, 2015

Inflation and the end(?) of the Zero Lower Bound

Inflation came in low again.  It will be interesting to see how this plays out over the next several months.  In 2 years, there has been 1 single month with core inflation above 0.2% and no months with Core minus Shelter inflation above 0.2%.

In the past 8 months, core CPI has risen by about 1.0% and Core minus Shelter has risen by about 0.3%.  Much of the Year-Over-Year inflation came more than 8 months ago.  As we move to June, YOY core inflation and core minus shelter inflation will have strong headwinds to overcome as months 9 through 12 time out of the inflation measure.  YOY Core inflation is very likely to still be well under 2% and core minus shelter well under 1%.

Shelter inflation has stabilized. Possibly if we are seeing the slightest whiff of a continuation in a housing recovery, this might slowly begin to decline.  That will either pull core inflation down even more, or credit expansion in housing might lead to inflation in non-shelter core categories.

In any case, it seems as though the Fed will have to conjure up some pretty strong forward expectations in order to justify a rate hike in the coming summer.  I'm just watching for now.  I suspect that there will be a window where expected short term rate movements are at their lowest and where nascent recovery in mortgage markets haven't triggered bullish expectations yet.  Maybe that point is now.  Maybe it will be in June.  At some point, there will be a profit in short forward Eurodollar contracts.  I might very well sit on the sidelines too long and miss it.  This is a tricky one.

Wednesday, March 25, 2015

Housing Tax Policy, A Series: Part 23 - Rent Inflation and Home Prices

Yesterday, I touched on the relationship between rent inflation and home price inflation.  Owner equivalent rent inflation has been above core inflation for 30 years and rent inflation in general has been higher than core inflation for 15 years.  I have made the point before that this is a very odd finding if we just saw a period of over building.  It's also an odd finding if the steep rise in mortgage debt was a product of median household desperation and stagnation.

Here is a graph of shelter inflation, core inflation, and the homeownership rate.  I would say that the general rate of inflation is a reflection of monetary policy.  The relative rate of shelter inflation is a reflection of tax policy, other public policies, and market trends which increase or decrease relative demand for housing.  The relative level of shelter inflation was low, briefly, in 1976, 1983, and 2010.  But, generally friendly policies and financial developments led to increased demand for owner-occupied housing in the late 1960s, late 1970, mid 1980s, 1990s, and 2000s.  These periods usually correspond to rising homeownership rates.  The high shelter inflation since 2007 has corresponded with sharply dropping homeownership rates.  As I showed yesterday, shelter inflation before this period came from owner equivalent rent, but this recent period has seen a rise in tenant inflation.  Earlier shelter inflation came from a shift right in owner-occupier demand, but this inflation is coming from a shift left in supply.  The shift in supply comes from the credit market, so the recent rise in rent inflation has been associated with very low home prices.  There is demand for housing, but there is no source of funds for it to be expressed in the owner-occupier market.

In any case, the direct relationship between rent and price only gets us so far.  Even using the Price/Rent ratio, home prices have risen from the mid 1990s levels by 47% to 100%, depending on the measure we use, and are from 22% to 68% higher than the previous high points seen in the late 1980s.

But, I think there is a more subtle interaction between rent inflation and home prices that has to do with homes as a financial security.  If we think of home ownership simply as a perpetual bond, which takes as its coupon payments the net rent on a particular house (after maintenance, taxes, and depreciation), a house is similar to a TIPS bond.  But, the inflation adjustment on a TIPS bond is based on the CPI.  On a home, the inflation adjustment is based on the specific local real estate market.

I think the required return of both homes and TIPS bonds begins at a level that reflects arbitrage with other investment alternatives.  With TIPS, this is relatively straightforward.  We can begin with the interest rate on nominal bonds and subtract expected inflation.  We usually go the other direction.  Since there is a market price for both TIPS and nominal bonds, we can infer expected inflation from the difference.

The sharp difference in real rates from 1978-1986 stems from the
sharp changes in inflation expectations, and the lack of a good
way to measure the effects of this on different durations. 
I submit that home prices operate in much the same way.  We begin with the nominal interest rate on very long term bonds, and we subtract expected inflation.  But, instead of inflation coming from the CPI, inflation comes from the specific expectation of nominal rent levels at that specific location.  This means that in areas where rent is expected to rise - growing cities, gentrifying neighborhoods, etc. - we should expect to see price/rent ratios much higher than average, because these homes will have a larger inflation discount.  And since all homes, no matter where they are located, should tend to provide the same expected present value of cash flows, the additional inflation discount on homes with higher expected future rents should lead to higher prices relative to the current rent.

Over time, I find that returns on homes, in the aggregate, do tend toward that non-arbitrage return level, relative to bonds.  Because they are perpetuities, there is much less cyclical fluctuation in home returns.  Also, they tend to have a premium (from liquidity, duration, and other complications of ownership) of about 1.5% compared to cyclically adjusted real 10 year treasury rates.

Comparing the nominal yield of 30 year mortgages to the real, implied yield of home ownership, we can perform the same inflation inference that we do with TIPS.  And, this measure produces an inflation premium very similar to the premium we see in TIPS and a real rate of return similar to what we see in cyclically adjusted real bonds, confirming that non-arbitrage pricing is effective in the housing market. (The real return on homes probably is approx. 0.5% higher than the real 30 year mortgage rate, because of the higher duration of the home, so this causes the inflation premium implied by mortgages and home returns to be understated by about 0.5%.)

The housing market has not been in equilibrium since 2007 (in other words, homes provide excess profit compared to fixed income alternatives - see the graph above with the output gap), so the inflation premium cannot currently be estimated in the housing market.  Even though real interest rates were low in the late 1970s, I originally thought that the high inflation rates must have dampened effective demand for housing by making mortgages unaffordable, which would depress Price/Rent (increase real returns).  But, real returns on homes did fall below 3% during that time, and the implied inflation premium is about where we would expect it to be for that period.  As I have looked at the data, it has begun to look as if low real interest rates were still incentivizing households into homeownership.  The homeownership rate rose in the late 1970's, and shelter inflation was strong.  But, imputed rent was falling as a portion of GDI until the Volker recession in 1980.  It looks as though households were moving into owner-occupied homes, but prices remained at the approximate no-arbitrage levels.  Normally, households would increase their housing consumption when they buy a home, because of the tax advantages of owning.  In the late 1970s, high mortgage payments were the obstacle to those excess gains, so marginal households had to downsize to capture it.  We can see in this graph that the average home price moved up relative to the marginal home price.  This downward shift for marginal home buyers created a positive skew in the homebuyer market, causing this shift.  (This may be a sort of just-so story, but I think that the market would have readjusted back to a less skewed market.  But beginning with the mortgage deduction in 1986, high income households were incentivized to consume more housing.  So, as nominal mortgage rates declined, marginal owner households consumed more shelter, but higher income households also consumed more shelter because of the mortgage tax deduction.)

Implications for Case-Shiller Home Price Indexes

I'm getting off track here.  The point of this post is that localized home prices, in theory, should be related to the local expectations of rent inflation, which could come from local development, zoning limits, or other local sources of shelter demand or obstacles to shelter supply.  As I laid out in yesterday's post, rent inflation has been higher in the 10 cities included in the Case-Shiller 10 city index than it has been in the rest of the country.  So, this would naturally cause prices to rise in proportion.  But, what I am describing in this post is a more subtle effect.  Persistently higher localized rent inflation would also increase the equilibrium Price/Rent level.  And, this is what we see in the indexes.

From 1985 to 2013, core CPI inflation averaged 2.8%, national Owner Equivalent Rent for Primary Residences averaged 3.2%, and OE Rent for Primary Residences in the 8 cities that have CPI measures from the Case-Shiller 10 city index averaged 3.5%.

So, simply using the rent level, the YOY rent inflation, and a very long term mortgage interest rate, implied from 15 year and 30 year mortgage rates (which ranges from 0.3% to 0.9% higher than the 30 year mortgage rate, depending on the steepness of the yield curve), I have a simple model of expected home prices to compare to actual prices.  Here, I am using the Case-Shiller indexes, so I have simply calibrated the modeled prices to roughly match the Case-Shiller indexes in the 1993-1994 time period.

I use the rent levels specific to the index (national OE rent for the National Index and average OE rent for 8 of the 10 cities in the 10-City Index).  I am simply using the rent inflation rate for a given year as my inflation rate adjustment.  In order to minimize noise from single-year rent inflation fluctuations, I have limited home price increases to a maximum of 15% per year.  I am valuing the homes as perpetuities, so the formula is very simple:
(CPI Rent Level) / (Estimated very long term Nominal Mortgage Rate - YOY Rent Inflation) * Constant
Here is a graph of the modeled prices corresponding to the National Index and to the 10-City Index.

At current interest rates, modeled home prices would be much higher, but they are limited by the 15% maximum gain.  In order for the modeled prices to fall back to today's market prices, long term real rates would need to rise by about 2%, which is about where they were in the late 1990's and at the high point in 2006-2007.  Long term rates are less volatile than short term rates.  It would be unlikely for long term rates to rise that high unless the Fed Funds Rate rises above 4%.

A reasonable scenario where the Fed Funds Rate rises to 3-4% by, say, early 2017, with nominal 10 year treasuries at 4% and 30 year mortgages at 5.5%, with typical 2.5% implied expected inflation, would put mature recovery home prices a little bit above where they are now - may 10-15% higher - with real implied returns on home ownership of 3-3.5%.  But, if the natural level of interest rates at full recovery rate levels ends up lower than that, there might be more room for home prices to rise before they settle in to a more typical, inflation level rate of annual appreciation.

A couple of implications from this projection:
1) Fed Funds forward prices are currently less than 1.5% in early 2017.  I wonder if there is a good hedged position to be taken here by pairing a short Eurodollar or Fed Funds contract with some sort of position that has long exposure to home prices.

2) Since long term real interest rates have been low and volatile, and since the effect of low real long term interest rates on durable real assets becomes stronger at lower rates because of the convex relationship between rates and asset prices, I think it would be much safer in this context to target 2-4% inflation instead of 1-2% inflation we have seen since the turn of the century.  Even in the early 1990's, Price to Rent levels declined by around 20% over a number of years.  Since inflation was around 4-5% at the time, nominal home prices remained stable and we avoided a mortgage crisis.  Eventually, secular real rates will rise.  A slightly higher inflation rate will probably create more stability when they do.

Higher inflation might dampen home demand slightly because of the higher mortgage payments that are required in a higher inflation context.  But, the inflation premium itself may create more stability than any dampened demand does.  Because, as I have outlined, since mortgages are a nominal security and homes are a real security, the inflation premium portion of the mortgage interest expense is really a pre-arranged purchase of home equity by the owner, from the lender.  In effect, because of our current conventions in home buying, higher inflation forces home buyers to increase their real equity positions in their homes at a faster pace.