Friday, September 4, 2015

Housing Tax Policy, A Series: Part 59 - The Effect of the Housing "Bubble" on Nominal Incomes

Yesterday's post was about the effect of rent measurement on inflation.  One common refrain about the 2003-2005 expansion period is that inflation and GDP measures for the period don't capture the extent of the monetary over-heating of the period.  Today, I thought I would look at those measures and see how they would look if we accept the basic premise of this view.

Gross Domestic Income with a Real Estate Capital Gain Adjustment

First, regarding GDP, the measure I will use is GDI, which tends to follow GDP very closely.  In a recent post, I referenced some research that calls to doubt whether any significant amount of new spending correlated with higher asset prices is related to a wealth effect, but some research suggests an increase of a few dollars per year for each $100 in asset gains.

I am using the quarterly change in the market value of real estate held by households, from the Federal Reserve's Z.1 Financial Accounts data, multiplied by 4 to estimate a seasonally adjusted annual rate of growth, minus fixed private investment in structures (since this would have increased the value of real estate in a way that is already reflected in GDI).  I am using, not just the gain in equity, but the entire gain in market value, so that I am capturing the possible effect of equity gains and credit expansion (the housing ATM).  For our exercise here, I am going to simply count half of the gains and losses in real estate as an adjustment to income.

Here's the graph of this measure, compared to unadjusted GDI:

Here are graphs of GDI and the adjusted GDI levels, in both log scale and linear scale, to get a feeling for deviations from short and long term trends.

There is a bump up in income in the late 1990s and then again in the 2003-2005 period that is larger than this adjustment had been in the past.  Generally what we see here is that nominal income growth was more moderate in the 1990s than it had been before 1980.  Even with the adjustment, nominal income in the 2003-2005 period is roughly similar to expansion periods before 1970 and is still much lower than the expansionary peaks of the 1970s.

As with so many of these measures, in hindsight, the bust was much more of a disruption than the boom.  So, if we are going to look at home prices as factor in nominal income, and give some weight to household capital gains and losses, then 2006 looks much more unusual than 2003-2005.  In fact, this isn't a terrible adjustment to make, in some ways.  It might even be helpful.  But, if we were to use this adjustment to GDI as a cyclical indicator, the most significant change this would have caused in our real-time reaction to cyclical fluctuations would have been to call for massive monetary accommodation by early 2006, because GDI adjusted for real estate capital gains was signaling the worst nominal downturn since at least 1950.

Inflation Based on Home Prices

To look at inflation, I have three series for comparison.  One is core CPI inflation with no shelter component, one is the standard core CPI inflation with rent, and the other is core CPI inflation with the change in home prices substituted for the change in rents (using the Case-Shiller national index).

Here, if we use home prices to create the core CPI, inflation levels in the 2000s tended to run about 4% - roughly between the levels of the late 1980s and the 1990s, but lower than the 1970s.  This measure of inflation rises to about 6% in 2005, though, of course, during 2005 the Fed Funds rate was rising from 2% to 4%, on it's way to the high of 5.25% in early 2006.

This indicator shows a collapse by mid-2007, similarly to the Core-minus-Shelter inflation measure.  So the timing is about the same.  But, the scale is much sharper, and the deflationary signal of this measure remains until 2012.

As with the GDI adjustment, there is some indication here of inflation on the high side of normal ranges during the expansion, but the signal of a deflationary shock that this adjustment gives comes earlier than traditional measures do, and is stronger to the downside than the expansionary excesses were to the upside.

Anyone using this adjustment in 2003 or 2004 to argue for monetary tightening must have been going mad in 2007, begging for monetary accommodation.  Really, from 2007 through 2011, someone using home prices would have labeled monetary policy as deflationary.

Ironically, it appears to me that using these adjustments can be useful.  I think monetary policy would have been more stabilizing and timely if these indicators had been given more attention.  Yet, where they were most useful were as early indicators of the economic crisis, and I don't think I know of anyone who mentions these indicators as signs of monetary excess in the 2000s who also uses them as signs of monetary deprivation after 2006.  This is the period where they give the sharpest signal, and I hope we can agree in hindsight, they gave signals that we would have benefited from acting on.

Thursday, September 3, 2015

Housing Tax Policy, A Series: Part 58 - Housing and the CPI

Adam Ozimek has an interesting article on rent inflation, which Matthew Yglesias previously referenced and recently tweeted a reminder about.  He argues that rent tends to be a sticky price.  CPI measures of rent and imputed rent measure average rents, which are an accurate measure of experienced inflation.  But, Ozimek argues that market rents - rents being charged in newly established leases - will reflect current market dynamics more accurately and aid in more responsive monetary policy.  This is a good point.

Here is a graph from the paper comparing year over year changes to CPI owner-equivalent rent, market rent, and Case-Shiller home prices in the Washington, D.C. area:

The market rent measure tracks the change in home prices more closely, collapsing and recovering earlier than CPI O-E rent inflation did going into and coming out of the recession.

I have used core-minus-shelter inflation as a way to avoid the misleading signals that shelter inflation has been giving.  A big problem is that shelter inflation reflects a supply problem.  But, it does seem as though using market rents instead of total rents may at least eliminate the problem of cyclical signals, even if the secular supply problem remains.

It looks like market rents might have given an even earlier indicator of demand problems than my core-minus-shelter indicator, but this may partly reflect idiosyncratic movements in Washington, D.C. real estate.

Also, it is interesting that O-E rent inflation for Washington, D.C. shows the same bump up in 2006-2007 that the national indicator does, but the market rent measure does not have the same behavior.  I have been using that movement as a sign of a supply constraint in housing coming from the early collapse in residential construction.  This could be an idiosyncratic factor specific to Washington, D.C., too, but if it does reflect a national difference in the data, it would weaken my supply argument during that period.  On the other hand, it confirms the weakness of inflation measures throughout 2006 and 2007.

There is some disagreement about whether home prices should be used as a proxy for shelter cost of living adjustments instead of imputed rent.  I strongly disagree with that idea.  That would be like using the price of bonds to measure inflation.  But, I can see why it seems like it would be a better measure.  I think partly what is happening is that home values are marked to market.  There is some price stickiness in home prices, but there isn't the sort of stickiness that differentiates ongoing lease rents from new lease rents.  We measure home prices only by recent transactions, so measured home prices reflect market prices in a way that CPI rent measures do not.

(Whereas rents for tenants with some tenure tend to dip below market rents, homes would probably have the opposite effect.  Homeowners tend to give their homes higher values than the market value.  We see this in a comparison of Survey of Consumer Finances to Flow of Funds data.  But, most measures of home prices don't use survey data.)

In any case, while I think that home prices are not appropriate as an inflation indicator, that doesn't mean they don't make a good cyclical indicator.  Price/rent or price levels may be good cyclical indicators, but this is because they are signals of changes in expected real spending growth or mortgage market disequilibrium.  It appears that for measuring inflation, Ozimek's market rent inflation measure captures some of the timeliness that home prices carry, but without some of the baggage.

Wednesday, September 2, 2015

Housing Tax Policy, A Series: Part 57 - It's Demographics, Housing Edition

The MBA report on housing demand that I referenced in yesterday's post included age-specific home ownership numbers, as of 2014, for ages up to 54 years old.  I decided to check demographic effects on homeownership by using these ownership rates as a benchmark, and apply them to census estimates of population by age over time.  I used only 25 to 54 year olds.

First is a graph of actual homeownership rates, quarterly.

Next is the homeownership rate we would expect to see of 25-54 year olds, assuming 2014 ownership rates for each age group.  In other words, the second graph shows how changing age demographics over time affected aggregate homeownership rates, assuming that the ownership rate of each age group has been stable.

It looks like homeownership rates were rising in the 1970s in spite of strong demographic trends pushing expected ownership rates down.  Demographics may have hidden the strong rise in homeownership demand created by inflationary factors.

On the other hand, demographics were pushing homeownership up in the 1990s and 2000s.

In the next graph, I have charted the actual homeownership rate.  Then, I have adjusted the actual homeownership rate with the ratio of the changing 25-54 year old aggregate rate given in the first graph.  Once we have adjusted for demographics, we see that the rise in homeownership in the 1970s was stronger than the rise in the 1990s and 2000s.  Once we account for demographics, we may not need much of an explanation for rising ownership after 1995.  I have previously argued that the rise in homeownership rates did not correlate that strongly with rising prices in the 1995-2005 period.  I had argued that if the rise in ownership in the mid-to-late 1990s was attributable to public programs like the CRA, those programs did not cause home values to rise relative to rents, because much of the increase in homeownership rates happened before home prices began to rise.  This demographic data suggests that public programs like the CRA may have had much less of an effect, even on homeownership rates, than it appears, at first glance.  A demographic explanation also explains how homeownership rates were rising in the 1990s and 2000s without any significant decline in homebuyer financial characteristics.  Demographically, there were simply more households naturally in a position to be owners.

Tuesday, September 1, 2015

Is it time to get back in to the homebuilder/treasury position

Some of this depends on the Fed, especially the Treasury half.  If they push ahead with too hawkish a policy, the yield curve could flatten.

But, on the housing side, I have heard twitter rumors of strong mortgage activity outside the banks.  Even real estate loans on bank balance sheets might be turning up again.  In the meantime, Calculated risk reports:

Very strong residential investment

Renewed strength in home price appreciation

Maybe recovery is finally coming?

Housing Tax Policy, A Series: Part 56 - Some Perspective on Housing Starts

It's really interesting to me how a decade into the housing bust, there is still a lot of public commentary based on the idea that a housing bubble is the defining element of our time, discussions based on the concern that we are entering a new bubble (sometimes based on the idea that rents are rising!), comments that there is a lot of visible construction activity in one city or another (much of this is commercial), and comments on macro-policy that we can handle cutting down on nominal incomes a little bit because the housing sector is now on solid footing.

It's a peculiar set of mental adjustments we are making here.  We have normalized our perceptions to the new reality of the bust without removing the overriding idea that we were, and are still, in, or at risk of, a bubble.  I think, largely, people simply haven't registered the scale and timeframe of what has happened since 2006.  My project for most of this year has been on a path leading away from the notion that there ever was something we could call a bubble.  But, even for anyone who may still believe that 2001-2005 reflected some departure from a sustainable level of construction activity, the scale of the ensuing bust dwarfs anything that happened before 2006.  If we simply have an unbiased reaction to deviations from long-term trends, then any reaction to the boom should be doubled or tripled as a reaction to the bust.  We should be marching in the streets for pro-building, pro-lending policies.  We should be "Occupying Wall Street" to open up the vaults and issue mortgages.

Bill McBride at Calculated Risk references a new report from the Mortgage Bankers Association about housing demand in the next decade.  As McBride points out, there should, conservatively, be demand for 1.5 million new units per year.  We are currently back up to about 1.1 million per year.  First, here is a basic chart of annual changes in population in the U.S.  The MBA report has much more detail on demographics and population.  There has not been, nor is there an imminent decline in population growth relative to previous eras.  Population growth and household formation have been lower after the crisis than they were before the crisis.  There have been many hypotheses about that, including changing cultural norms for millennials, anxiety about homeownership because of the bust, general economic malaise, etc.  The false notion that we had overbuilt housing in the 2000s seems to keep the most obvious problem from being widely noted.  We don't have enough houses.  We have undermined the mechanisms that households would utilize to create housing.  It's hard for households to form it there aren't houses.

Here is a chart of housing starts, going back to 1959.  That 1.5 million unit level mentioned by Bill McBride goes back to the beginning of the data series.  If we track housing starts all the way up to July 2003, the long term trend is a dead flat 1.521 million units per year, for 44 years.  Housing starts had been unusually below trend in the late 1980s and early1990s.  Even though some rumblings about housing bubbles had begun as early as 2001, housing starts even into 2003 were not very far above that long-term average, and the 10 year moving average was pretty close to that long-term average.

Even if we look at the entire period through 2005, total housing starts were not particularly high compared to previous expansions.  But, if we create a discontinuity at July 2003, where housing starts had recovered enough to pull the long-term trend back to level, and look at housing starts in the 12 years since then - including both the "bubble" period and the bust period - average starts have come at an average rate of 1.166 million per year.  That adds up to about 4 million homes missing from the U.S. economy.

If the drop in household formation has been more a result of the housing bust than a cause of it, there is a lot of catching up to do.  The MBA report notes this, to an extent, but to the extent that the bubble narrative is pulling down expectations, I think even their numbers may be understated.  Looking at my graph of housing starts, the drop in starts is unprecedented and extreme.  Even now, we have really only recovered back to what would have previously been considered extreme recessionary building levels - and this is after nearly a decade of levels well below any previous experience.  The scale of the hole we have blown in the American housing stock should be shocking.

I have appended a hypothetical future building level onto the graph, which represents 3% monthly growth (over 40% annual) until starts reach 2 million per year.  This would have to be the case until 2023 just to pull the long-term trend back to a level 1.5 million.  It would be 2021 before the 10 year moving average of housing starts moved above 1.5 million in that scenario.  The boom we need just to regain previous generations' levels of housing availability would need to be much larger than what we saw in the 2000s.  We would need 2005 level housing expansion for 7 years.  In short, sadly, the level of housing construction this country needs is massively more than we will ever allow.

Real housing expenditures, as estimated by the BEA, have been falling since the early 1980s, compared to other personal consumption expenditures.  One natural counter-reaction to my argument would be to wonder if the natural trend of housing starts has been declining instead of remaining level, which would cause the bust to be overstated.  Considering demographic and population trends, and the fact that rent inflation began to run persistently above core inflation in the mid-1990s, only moderating during the top of the boom in 2004-2005, it is more plausible that the long-term trend housing actually should have been rising during this period.

Some of the housing growth required to make up that additional shortfall would come through housing starts.  But, much of it would come through higher home values (in terms of rental value).  That doesn't necessarily mean that American households need larger homes, though some wouldn't mind having larger homes.  Much of that value would be location value.  That is tied to our urban core regulatory problems.  That is a whole different problem.  Until we solve that problem, the houses we build will be in second-best locations where building is welcomed.

But, whether we solve this problem with second-best housing units in Arizona and Nevada or with housing units in San Francisco and New York City, we have a heckuva lot of houses to build.

Monday, August 31, 2015

Housing Tax Policy, A Series: Part 55 - Housing and Wealth

Here's an interesting speech that I happened upon recently (HT: Matthew Klein via Noah Smith)
"Philip Lowe: National wealth, land values and monetary policy" 
Address by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the 54th Shann Memorial Lecture, Perth, 12 August 2015.
Mr. Lowe's commentary is mostly devoted to Australia, but the issues apply just as well to the U.S., and, in fact, I think the universality of these issues in developed economies may explain how problems that originate in localized housing politics may have aggregated into a problem that affects global fixed income markets.  Much of Mr. Lowe's discussion builds around this issue:
almost three-quarters of the increase in the ratio of net wealth to GDP since the late
1980s is explained by higher land prices.
This isn't quite the case in the U.S.  It should be, but we threw our housing sector into disequilibrium in 2007.  Australia didn't.  But, even before that, it looks to me like housing only accounted for more like half of the increase in wealth to GDP in the U.S.  I suspect that one reason is that foreign corporate investments are a larger portion of U.S. wealth.  This doesn't show up so much in book values in the U.S. capital account, but it does show up in the market value of U.S. corporations.  The first factor he cites in raising those prices is lower inflation and less financial regulation.  I had originally intuited that as a significant factor in rising home prices, myself, before I began this series of posts.  I outlined Friday why I don't think the data confirms that intuition.  In addition to the confounding pieces of evidence I discussed in that post, I have discussed previously how rising home square footage is another piece of evidence that looks at first blush like it is a sign of overbuilding, but may actually be a result of supply constraints.  Since I wrote that post, I have come to that view even more strongly, since the concentration of those supply constraints in the core cities should cause an even larger substitution of square footage for lot size.

Lowe continues:
The second factor is the combination of strong population growth and the structural difficulties of increasing the effective supply of residential land....They include the challenges of developing land on the urban fringe and of rezoning land close to city centres for urban infill. They also include, in some areas, underinvestment in transportation infrastructure. This underinvestment has effectively constrained the growth in the supply of “well-located” land at a time when demand for this type of land has grown very strongly. The result has been a higher average price of land in our major cities. Another possible structural explanation is that the higher land prices reflect an upward revision to people’s expectations of future income growth and thus the amount they are prepared to pay for housing services. One possible reason for this is that the growth of our cities generates a positive externality – by bringing more people together competition is improved and productivity is higher. While this might be part of the story, I think it is unlikely to be a central part. Real income growth per capita did pick up markedly from around the mid 1990s, but it has subsequently slowed substantially, with apparently little effect on the price of land relative to income. So the story is really one of increased borrowing capacity, strong population growth and a slow supply response. done by my colleagues at the Reserve Bank of Australia (RBA) has estimated that a rise in wealth of $100 leads to a rise in non-housing spending of between $2 and $4 per year. (11)....Interestingly, other colleagues at the RBA have recently been examining this idea, again using household level data from the HILDA Survey.13 They find clear evidence in favour of a collateral channel, especially for younger households who are more likely to be credit constrained. In contrast, they find no evidence in favour of the traditional pure wealth effect. Instead, their evidence is consistent with the alternative expected-income idea. Perhaps, the most intriguing aspect of their results is that when housing prices in a particular area increase, renters in that area increase their consumption. The increase is not as large as for owner occupiers, but it is an increase. The conclusion that my colleagues reach is that it is a common third factor such as higher expected future income, or less income uncertainty, that is, at least partly, responsible for the observed association between housing wealth and spending.

That last point is interesting, and I think ties in with this NBER paper from Hsieh and Moretti that I recently discussed, which suggested that housing constraints in high productivity cities cause some of that productivity to be captured as economic rents by laborers and real estate owners in the city.  The Windsor, Jääskelä and Finlay paper he cites finds that when home prices rise, there is no measurable wealth effect that leads to growth in consumption.  Instead there is some credit expansion for credit constrained households and there is, surprisingly, increased consumption for both owners and renters, which they take as a signal of increased income expectations.  (I think we could also say that the credit expansion, in the aggregate, is related to positive future income expectations.)  I think it is plausible that the base causal factor here, given a city with high or increasing productivity, could be the housing constraint, which limits labor inflows to the city, pushing up wages and real estate rents.  This would lead to higher real estate rents and values, and to higher income expectations, credit usage, and consumption from both renting and owning households.

To the extent that labor movement is flexible, these rents should eventually accrue mostly to real estate owners.  This should happen most readily among low income households who benefit the least (in absolute terms) from the city's productivity opportunities and who spend a larger portion of their incomes on rent.  I think this fits well with the common observation that urban real estate is being developed only for the ultra-rich.  That is because very high income workers are still claiming some of the rents of the limited access city, and the process of building new high end real estate is the process of real estate owners claiming more of those rents.  Thus, the largest beneficiaries of urban policies that dis-incentivize building and require more low rent building are probably the city's very high income wage earners.  This is because their marginal housing consumption is more discretionary, so they can reduce their real housing consumption to retain more of the available rents.  I wonder if this is why the priciest units seem to be purchased by what Krugman referred to as "domestic malefactors of great wealth, but also oligarchs, princelings, and sheiks", because the very high income households who are in the city for productive reasons would be reducing their housing consumption during their tenure in the high-cost city - possibly downsizing their urban space and pairing it with a spacious home in the country.  The constricted supply turns the highest rent units into very effective luxury status goods.

I am starting to wonder how much of the measured trends in income inequality have their source in the housing policies of the major cities.  I think there was generally an expectation that the technological revolution would make location less important.  But, we have found that for the creative functions behind that technology, location has become more important.  And, globally, cities have developed housing constraints that have prevented them from accommodating the inflows of creative and productive workers who find value there.  Lowe mentions the importance of transportation.  Will the trends in income distribution reverse when the self-driving car becomes widely available?

In the meantime, I think Lowe has missed an important implication of these various findings.  He doubts that the higher value of urban real estate has come from higher expected incomes.  He says, "Real income growth per capita did pick up markedly from around the mid 1990s, but it has subsequently slowed substantially, with apparently little effect on the price of land relative to income."  But this is because real incomes are lowered by the rising rents themselves.  Income expectation in the cities are, indeed, strong.  But the rising incomes are eventually claimed by real estate owners.

Distributional Effects of Home Price Changes

In an economy without supply constraints, rent and home prices should rise with inflation over the long run.  In this case, rising income expectations should coincide with higher real interest rates, and future real increases in housing consumption would come from future increases in the real value of the housing stock.  This is actually a good description of the housing market of the 1990s, when rent inflation wasn't excessive (until the last half of the decade) and price/rent ratios were low.  So, I think the positive correlation of income growth expectations and home rents and prices is only operative in a constrained supply context.  Or, to restate this in a more narrative way, without supply constraints, households with rising incomes wouldn't pay more to rent or purchase homes; they would just build better homes to add to the beginning housing stock.  In that case, there wouldn't be a correlation between rising incomes and rising rents or prices of the existing housing stock.

Here, I would like to pull in the recent paper from Song, Price, Guvenen, and Bloom at the LSE.  They found that essentially all of the change in income inequality since 1982 has happened between firms.  In other words, distribution of incomes within firms has been relatively stable.  The highest income workers aren't earning relatively more than their co-workers than they used to.  Rather, workers of all incomes at the highest paying firms are making more than workers at other firms.

Some of this could be explained, I think, by changing firm structures.  For instance, Apple's corporate structure outsources much of the lower value-added positions.  More generally, technology-related fields have largely developed around human capital, more than physical capital, leading to firms filled with high income professionals and entrepreneurial development-oriented technology workers.  But Song, et. al. seem to find that the pattern holds when controlling for industry type, worker age, gender, and tenure, firm size and region, and is stable over the time period.

I have included the graphs by region here.  The x-axis on the graphs is the income percentile of the worker.  The blue line is the change in income for workers in each percentile from 1982 to 2012.  The red line is the amount of that change that can be explained by the average income of the firms the workers in that percentile worked for, and the green line is the amount of that change that can be explained by the change in incomes for that percentile, relative to their co-workers.

When the data is separated by region, there are distinct bumps in the bottom 30% of incomes.  Except for the very lowest wage earners, these workers saw rising incomes compared to their coworkers.  We see the opposite pattern at the top of the wage scale, though not generally as pronounced, where high income workers saw their incomes rise slightly less than their co-workers, except for a slight positive bump for the top 1%.

Some of this must be related to organizational shifts.  Maybe there is an explanation for the hump at the low end of wages related to the shift from manufacturing to health & education and leisure & hospitality.  I wonder if there is generally a bit of a rural vs. urban divide here, and that the distribution of firm wage gains would be flatter if we applied location specific inflation adjustments.

A careful viewing of the scales of these graphs shows that the West and Northeast regions have much sharper divergence between the top 15% of firms and the rest of the firms - a divergence of earnings growth between high income firms and other firms of about .4 compared to .2 in the other regions.  These are the regions where the cities with the worst housing problems are located (NY, San Francisco, San Jose).

The urban housing supply issue may be a fundamental driver for all of these issues - income variance, the sense that we are in a "bubble" economy where income gains are soaked up by rising asset prices, the sense that real incomes for the lowest income earners are stagnant.

More Distributional Effects of Home Price Changes

Let me define a static housing context as one where interest rates are stable, and the real housing stock is expanded at the rate of real income growth, so that each year, households spend the same portion of their incomes on housing, and they increase the real value of their homes (through size, location, etc.) as their incomes grow.

Now, if long term real interest rates decline, this simply reflects a change in the price that current savers have to pay for a claim on future rents.  This is a transfer from future buyers to current owners.  There are some distributional effects here, but only between owners.  High long term real rates probably promote economic mobility by allowing new savers to more easily pre-pay future rent and by reducing the nominal value of past savers.  But, there is no first-order effect on home consumption (rent).  This explains some of what has happened over the past 20 years or so.

But, all else equal, what if there is a shock to expected future housing supply?  This will also cause home prices to rise, but now, this isn't simply a transfer of cash from buyers to sellers.  In this case, the buyers are actually buying more rent.  One way of thinking about it is that a single property now represents a larger portion of the future housing stock than it did in our beginning stasis condition.  This is similar to buying stock in a firm with that has an above average growth rate because it is gaining market share.  It fetches a higher price, just as the home now fetches a higher price.  At the point of recognition of this change, home owners will receive a one-time capital gain.  This is like owning shares in a firm that announces a positive product development.  Or, maybe, more precisely, it is like owning shares in a firm that announces protectionist developments - say, the value of a domestic tire manufacturer after a large tire tariff is announced.

In that scenario, the ability of securities markets to pull future developments into the current price creates something that looks like a disconnect to a naïve observer.  Rent isn't forward looking.  It reflects the current supply and demand for housing consumption.  So, the higher home price will appear to be inflated.  But, since the home itself is a static property, it's value relative to a given future housing stock is static.  A new owner must purchase that home's portion of the future housing stock, whether they want to or not.  If housing consumption continues to command a stable portion of total consumption expenditures, as it has for more than 50 years, then there may be conceptual value to thinking about home values in terms of future housing "market share".

Thinking about it this way, adding potential supply will reduce the value of existing homes by reducing their future expected housing "market share".  I have wondered how much the lack of available investment in real estate has been a contributing factor to lower real long term interest rates.  But, I wonder if this presents another way of thinking about that.  Normally, risk free real interest rates would tend to rise and fall with expectations for real economic growth.  So, current low real interest rates suggest low growth expectations.

I wonder if this is related to the current tendency for home prices to rise to unusual levels.  The expected growth of the housing "market share" of individual home owners is basically a claim on future nominal income growth.  It is the result of artificial limits on housing expansion - limits to real growth, which operate as growing claims by real estate owners on future nominal incomes.  The added value of home ownership and lower expected future real income growth expectations are two sides of the same coin.

This is sort of an application of limited access vs. universal access.  A universal access economy will lead to creative destruction and growth, and real risk free interest rates will reflect the related optimism.  A limited access economy will lead to rent-seeking, and real risk free interest rates will reflect stagnation.  A large portion of our economy (housing) is characterized by limited access - first through urban building policies, which pushed real interest rates down slightly in the 2000s, then through limited mortgage access policies, which pushed real interest rates down to the extremely low levels seen since the 2008 crisis.

Friday, August 28, 2015

Housing Tax Policy, A Series: Part 54 - Two Stories of Housing Supply and Demand

A review:

Excessively accommodative monetary policy led to over-expansion of credit and mal-investment, leading to a massive over-consumption of housing.  Where that overconsumption couldn't be met with supply, prices skyrocketed.  As predatory lenders approved households for more and more housing, households bid up the price of homes, pumping up the price of owner-occupied properties as households moved out of their rented apartments into their shiny new McMansions which were more house than they should have ever been allowed to own.

As regular readers know, I have previously pushed back against this narrative.  Well, now that I have reviewed the data, I must confess that this narrative does fit...


...It fits the 1970's, that is.  Which, it so happens, was a period that actually had excessive monetary accommodation.  Well, the narrative fits if you remove the rapacious bankers and replace them with reasonable households.

I might need to explain the graph.
The green line is core inflation - a pretty good proxy for monetary policy, given that our stated policy is an inflation target.
The purple line is shelter inflation, relative to core inflation.  Owner-equivalent rent inflation only goes back to the early 1980s, but since it accounts for the bulk of the Shelter component, shelter is a very good proxy that goes back much farther.  I have not adjusted this measure to remove non-owner rent inflation, but this tends to have a small effect, which would mostly just amplify the patterns we see here.
The blue line is rent inflation for non-owners, relative to core inflation.

As we enter the 1960s, inflation is low and shelter inflation is unremarkable, but beginning in 1966, inflation kicks up and remains high until after the Volcker adjustment.  Notice the interesting pattern throughout that period.  Whenever inflation shoots up, relative rent inflation moves down and owner-equivalent rent inflation moves up.  Notice, too, how the late 1960's and late 1970's episodes, which coincide with the sharpest owner-equivalent rent inflation also see run-ups in homeownership rates and in real estate values.  That is what a demand-side housing boom looks like.

What caused me to look at this more closely was a very interesting speech by Philip Lowe, Deputy Governor of the Reserve Bank of Australia.(HT: Matthew Klein via Noah Smith)  (I will have more to say about that speech in my next housing post.)  One factor Mr. Lowe mentions regarding recent home price behavior is:
In the 1970s and 1980s, regulation of the financial system and high inflation served to hold down land prices artificially. They did this by limiting the amount that people could borrow. When the financial system was liberalised and low inflation became the norm, people’s borrowing capacity increased. Many Australians took advantage of this and borrowed more in an effort to buy a better property than they previously could have done. But, of course, collectively we can’t all move to better properties. And so the main effect of increased borrowing capacity was to push up housing prices, and that means land prices.

I'm not sure about much of this anymore.  First, I'm not sure why we can't all move to better properties.  There is a lot of unused space 100 to 1000 feet above the major cities, in Australia and the US, and building costs aren't as high as one might think.

I originally thought that unprecedented low mortgage payment levels in the 2000s reduced barriers to credit, and that this was a cause of low cash yields (high price/rent) in the 2000s.  Mr. Lowe's assertion seems intuitively reasonable.  But, this assertion is, surprisingly, not supported by the data, which shows strong single family housing starts, rising owner-equivalent rent, rising home values, and rising homeownership rates during both the 1970s and 2000s.

And, even more surprising, even while all of these indicators of growth were strong during both periods, growth in real housing expenditures stepped down to permanently lower levels coincidental with both periods.  That's a pretty strange thing to see during a building boom.

Looking at the 1970s, the demand for homeownership was probably related to the high inflation of the time.  Not only did homes provide a hedge against inflation, they provided a tax-sheltered hedge against inflation.

These various trends are what we would expect to see in an efficient market.  The incentive toward ownership would lead to reduced renter demand and increased owner demand.  Owner-occupied expenditures would be inflationary, because the tax benefits of ownership (imputed rent paid to oneself is tax exempt, as well as much of those inflation-fueled capital gains) would shift the demand curve of owner-occupied housing to the right.  (Another way to think about this is that the increased tax benefits created by high inflation pushed pre-tax owner-equivalent rent up, but after-tax O-E rent may not have changed substantially.)

Higher rents and low real interest rates may have pushed the nominal price of homes up, and higher demand for homeownership may have pushed up single family housing starts.  But, the trend in real housing expenditures suggests that marginal households were lowering their real housing consumption in order to transition into homeownership.

This explanation (easier access to credit because of low interest rates) was part of my original explanation for the housing boom of the 2000s, but upon closer inspection, I don't think the evidence points to a very strong effect.  There are many confounding factors that create false impressions that overstate this effect.  In addition to all of the moving parts described above, when real long term interest rates fall, they cause the intrinsic value of homes to rise at the same time that they would appear to increase demand for homeownership due to easier access to credit.  But, the lack of an increase in real housing expenditures during these periods of low real rates suggests that it is the rise in intrinsic value that is operable.  Households weren't moving up into more valuable homes (in terms of rental value) during either period.

Another confounding clue is the change in tax laws in 1986 that created new value for home mortgages because of the mortgage interest tax deduction.  Note that O-E rent did begin to fall along with home ownership after inflation began to subside in the early 1980s, but permanent reductions in inflation happened slowly, and the added tax advantage of the mortgage deduction moderated the market reaction.  I think this probably helped homeownership remain at about 64% into the 1990s and produced some moderate O-E rent inflation in the late 1980s, relative to renters inflation.

Beginning in the mid-1990s, rent inflation for both renters and owners began to run persistently higher than core inflation - with renter inflation tending to run slightly higher than owner inflation.  As I have pointed out before, home prices didn't begin rising until around 1998.  Half of the recent (temporary) increase in homeownership happened before any substantial rise in home prices.  This rise in homeownership doesn't appear to have any significant effect on prices or housing consumption.  This could be related to Community Reinvestment Act policies, but is unlikely that it is related to mortgage rates.  Rates in the 1990s were lower than the late 1970s, but they were still relatively high.  And, there were some increases in non-traditional lending, but nothing like the scale of the 2000s.

This period doesn't have the rent inflation signature of the 1970s.  And, along with the persistently high level of renters inflation, there is no cyclical supply response in multi-unit housing starts during this period.  The demand curve for home ownership hasn't shifted to the right; the supply curve for rented real estate has been stuck to the left.  The first time credit access really became a factor in housing markets was around 2006.  Since then, homeownership rates have collapsed, and for the first time, there has been a sharp divergence between the expected rate of return on homes and the rate of return we would expect in a market with broad access.

Here is a graph I have posted before, I think.  Before 2008, the inflation premium inferred by the difference between real returns to homeowners and effective nominal mortgage rates was a pretty good approximation of expected inflation.  In other words, housing markets were efficient.  In fact, considering the persistently high rate of rent inflation since the mid 1990s, the implied return on homes in the 2000s looks fairly conservative by this measure.  Even if effective mortgage rates at the time were reduced by the use of adjustable rate products, and a duration adjusted inflation premium at the time was more like 3% instead of 2%, this would not have been unreasonable.  But, after 2007, this long-standing arbitrage relationship broke down.  Real returns on home ownership have been higher than nominal mortgage rates, even in the face of the return of high rents.

I think there is a lot of confusion about supply and demand in housing that comes from conflating home ownership with housing consumption.  The presumptions we make about housing are the equivalent of seeing a sharp rise in bond purchases, and concluding that people must be spending and consuming more.  Home ownership is a claim on future cash flows, and it appears to me that the price of those claims, in the aggregate, is as systematic and regular as we would expect from any security with variable, but relatively stable, cash flows.

Home prices are efficient.  Nominal housing consumption is pretty stable over time.  Nominal housing expenditures seem to have reached a stasis around 1960.  Notice how the slight dip in relative nominal housing expenditures is during the inflationary period where home prices and demand for home ownership is rising and real housing consumption is stable. (The bumps in real housing expenditures around 1975, 1980, and 2008 are mostly related to drops in real incomes associated with deep recessions.)  The secondary effects of inflation increased demand for ownership, not for consumption.  This seems to have had more effect on the housing market than limited access to credit did.  Remarkably, prices and net returns on investment appear to reflect reasonable estimates of long term real required returns.  Real returns on homes were declining in the late 1970s, as did real long term bond rates.  To the extent that high mortgage rates created a market reaction, it appears that nominal expenditures - rents (paid and imputed) - adjusted while home prices remained efficient, leaving no unusual profit opportunities.

Supply is the irregular variable here - the variable that isn't either stable or predictable.  As real housing supply declined from the mid 1990s to the crisis, relative to other expenditures, nominal consumption remained stable, and prices were an efficient reflection of constricted supply.  Now, the systematic nature of prices has broken down, and will remain broken until either owner-occupier credit becomes vital again or investor ownership continues to climb long enough to fill the void.  Until then, rising rent will be the story of housing.

The obsession with "bubbles" and confusion about housing means that rising rents will be widely perceived as a "bubble", regardless of whether home prices fully recover or not.  As long as supply remains low, high rents will make just about any price seem high, even if it's 30% below intrinsic value.  The resulting destruction of demand imposed to fix the "bubble" will do nothing to solve the supply problem.  But, I suppose our lower real incomes will make us miss the homes we couldn't have built anyway a little less.  We won't have to deal with any of those gauche rich people trying to buy condos in San Francisco.  So, we'll have that going for us.

Thursday, August 27, 2015

Bond market update

By my model, last Thursday, the mean expected date of the first rate hike was around the end of November, suggesting about a 30/70 split of a rate hike in September vs. December.  The mean date has moved forward to the beginning of March - a full quarter move.  Uncertainty has increased, so there is still some expectation of a September hike, but this also means there is some expectation of a hike later than March.  The slope of the curve hasn't changed much, but the long end has actually moved up a bit.  So, on the Eurodollar curve, from the close last Thursday to today, 2016 rates are a little lower, 2017-2018 rates are about the same, and rates at the long end of the curve are up about 14bp.  This suggests to me that the bond market sees hope for a more dovish future trend coming from the expected capitulation by the Fed to delay the rate hike.

This shift puts us back at about 6 months away from the next hike, continuing the pattern of the future rate hike date shifting ahead in time whenever there is not a QE program in place.  There may be enough momentum to eventually break that pattern now, especially if we can see any renewed expansion in real estate investment.  But, it would be nice for the Fed to just pull the rate hike off the table for a while.  What does everyone think is going to happen?  Five percent NGDP growth?  Two percent inflation?

If the Fed announced tomorrow that there would be no rate hikes until at least June 2016, the slope of the yield curve and long term bond rates would rise immediately.  Wouldn't that be normalization?  That looks a lot more normal to me than what people are calling normalization.

The slope of the yield curve after the first hike is around 20bp per quarter until it flattens out around 3%.  Normal yields in every recovery since the early 1960s have risen by at least 50bp per quarter, up to more than 5%.  And in the recoveries before that, when rates were lower and rose more slowly, NGDP growth was topping out at 10%.  There is a lot of leeway between here and normal, let alone between here and reckless.

There is a great way to know if the Fed is being reckless, too.  If it ever becomes too accommodative, equity values will fall relative to corporate operating profits, like they did in the 1970s.  Anti-market bias leads to this massive case of attribution error, where we each individually know just what a "bubble" looks like and how to avoid it, but "those people", otherwise known as "the market", or "us", will be led down the primrose path.

Wednesday, August 26, 2015

A Pre-HUD monetary regime

Yesterday, Ironman at Political Calculations made the following suggestion:
So what should the Fed do? We would suggest that the Fed do nothing, but in a creative way. The Fed should announce that it will indeed hike short term interest rates as planned in September 2015, and at the same time, that it will also initiate a new round of quantitative easing, initially at a low value with the amount being data dependent with respect to actual economic conditions within the U.S. economy, with the stated goal of achieving a nominal GDP growth rate target it believes it can attain by the second quarter of 2016.
At first, this seemed a little frivolous, but the more I thought about it, the more this started making sense to me.  This fits well with my conception of our current economy that is bifurcated between (1) an industrial expansion which is happening, more or less, at terminal velocity, which would probably normally be associated with short term interest rates at least in the 2% to 3% range and (2) a real estate economy which is held back by regulatory barriers to building and to credit access.

Real housing consumption is, therefore stagnant, and the relatively low elasticity of housing demand leads some of the real growth in the industrial economy to bleed into real estate.  Limits to real housing expansion mean that this increase in housing demand mostly becomes rent inflation.

So, I have, tentatively, held the opinion that early rate hikes may not be that important, because housing isn't constrained by rate spreads and the industrial economy can withstand some rate increases.  Recent market reactions suggest that I might have been too optimistic about that.

In any case, it seems to me that we have come to a new consensus that debt-financed housing is in disfavor.  All things considered, housing wouldn't have to be financed through highly leveraged bank loans.  There are numerous ways that we could conceive of a functional housing system, and some would probably operate more smoothly.  But, the problem is that since there is a focus on the misguided idea that the main problem was high home prices, unmoored by fundamental values, there tends to be a satisfaction with prices that remain low.  This satisfaction requires a willful disregard for the alarmingly low rate of new homebuilding and high rate of rent inflation, and a disregard for the unprecedented level of excess returns available to home owners at current price levels.  So, we have completely undermined our previous system of home ownership (in that expected returns cannot fall to non-arbitrage levels) and there is no consensus demand to replace it with a functional system.

Where this is leading is to a pre-HUD context, with very low homeownership rates and high equity levels (low leverage) for homeowners.  If this is the context we are determined to create, then we need to provide enough liquidity in the market to fund cash ownership.  And, as long as we withhold that liquidity, homebuilding will remain very low, rent inflation will remain high, and real estate owners will capture excess gains.

When we did have this sort of context before 1960, the banks held a large amount of securities in bank credit (treasuries, etc.).  I am no banking history expert, but I suspect that part of what was happening was that there was more demand for insured bank deposits than there was supply of bank assets with credit risk, so banks met some of the demand for deposits by holding treasuries.  (Please, correct me in the comments if I am wrong.)  Maybe today low risk non-bank savings vehicles would fill some of this demand.  Or, maybe even those avenues create some level of bank deposits.  Again, educate me in the comments if you can.
Note: the x-axis begins in 1973 on this graph.

The last piece of the puzzle here is that with our new policy of paying interest on reserves, reserves are basically a substitute for short term treasuries.  Benjamin Cole, blogger and occasional IW commenter, favors a sort of permanent QE.  And, thinking about it in terms of bank balance sheets, I think he has a point.  This is probably inevitable.

Now, I'm not sure what factors have led banks' overweight low-risk holdings to be in reserves today vs. securities back then.  Is it because of the peculiar path of monetary policy an interest on reserves beginning in 2008?  What if there was a way for the Fed to swap reserves for treasuries with the banks without creating deflationary side effects?  In any case, it seems as though the large Fed balance sheet is only different from the pre-1960 context semantically.

And, if that is the case, then it does seem like there are two tiers to future monetary policy, if we are going to retain interest on reserves.  First, is management of credit through the level of interest on reserves, and second is management of the level of bank deposits through open market operations.  To this end, a rise in interest on reserves coupled with large scale purchases of treasuries makes sense.  Treasury purchases would allow deposits to rise, even as banks were using deposits to purchase low risk securities in the form of excess reserves.  Presumably some of the cash from the open market purchases would make it into real estate markets, allowing real estate values to rise to non-arbitrage prices without the use of destabilizing debt.

This is all academic, really, because the same errors that have led to a consensus against mortgage growth would lead to curtailment of asset purchases if returns to home owners ever reaches a reasonable level, and, further, most of the potential benefits from injecting liquidity in the housing sector would depend on removing the fetters from urban residential building markets.

The public wants to spend about 18% of personal expenditures on housing, but we have a number of policies that divert those expenditures to real estate owners instead of to developers and builders, then when the inevitable pressures to rent inflation and real estate values build, we complain of stagnation and the "bubble economy".  But, instead of prescribing supply, we prescribe demand destruction.  Nothing besides real expansion of housing (mostly through the unleashing of location) will solve the stagnation problem, and I don't see any immediate possibility of remedying that problem.

But, in the meantime, Benjamin's and Ironman's QE4+ would be one way of allowing real estate prices to reach a reasonable level.  We would know when we had gone too far because inflation would begin to rise.  If real estate prices rise in a low leverage environment and we don't see consumption inflation, then who is to complain?  In fact, to the extent that new housing stock is encouraged, QE4+ would be deflationary.  Most of our current inflation is due to rent inflation because of the housing shortage.  If your complaint about the regime that I just described is that only high net worth households would be able to own homes, then I will suggest that you're arguing for a return of widespread mortgage financing.  If we pick neither, then we are picking a regime that not only locks to net worth households out of ownership, but also keeps their rents high in order to fund the excess returns of their landlords.  Of the three options, our current regime is the worst.  I'm afraid that the other two regimes require supporters who are willing to accept market prices, which is a sadly unpopulated cadre these days.

Tuesday, August 25, 2015

Scott Sumner on policy and civility

Scott discusses "How bad government policies make us meaner".  It's hard to excerpt, but the basic idea is that if we legislate favorable contracts, we create incentives for discrimination and abuse.  A landlord of a rent controlled apartment has no incentive to treat tenants fairly.  There will be a line of tenants ready to take the current tenant's place, in any case.

Proponents of the minimum wage frequently reference these factors in defense of minimum wages - the idea of efficiency wages, that there will be lower turnover, and that employers will have a larger potential labor force because workers will be more incentivized to take the higher wage jobs.  Among the outcomes, in other words, employers will have more leeway to be abusive and prejudiced in their hiring decisions, and workers will be more apt to put up with indignities in order to keep their jobs.

This is related to my post from the other day about the importance of freedom of entry.  Really, this is all related to Mike Munger and Sam Wilson's Euvoluntary Exchange project.  I must be honest that in some ways I am still wrapping my head around the conceptual insights of EE.  But, a foundational element of the concept is that the availability of nearly equivalent alternatives is probably the most important element in creating a culture of fair dealing.  If you crawl out of the desert, parched, to an oasis, the difference in ethical context of meeting one person with some water versus meeting 2 or 3 people with water is enormous.

Policies that intend to help workers or consumers by lifting particular contracts away from available alternatives are very short sighted.  They are inimical to a civilized and fair society.