Good News! There Was No Housing Crash

At least according to the US government.

The BLS claims that housing prices are up 2.1% in the last 12 months. Why does this matter? For all sorts or reasons, but first let’s try to figure out what really happened. According to the BLS, housing makes up nearly 40% of the core basket of goods and services.

Category     weight        inflation

Housing        39 %            2.1%

Other             61%            1.4%

Overall          100%           1.7%

Suppose that instead of rising 2.1%, housing costs have actually fallen 2.1% over the past 12 months? In that case the core rate would be zero. Which number seems more likely? For much of the past year house prices have been falling at more than 2% a month.

At this point you may be wondering how the government could be so stupid as to think house prices have risen 2.1% over the past year. Well they may be stupid, but not THAT stupid. They are trying to measure something called the “rental equivalent” cost of housing. Yet by all accounts even monthly rents are falling rapidly. So why do they show 2.1% inflation of housing prices? I’m not sure; perhaps someone can answer these two questions:

1. Do they factor in the effect of deals that include one or two months of free rent? I don’t think they do. These are much more common during a downturn, and are disguised price cuts.

2. Do they survey all apartments, or just newly rented units? I hope it is the latter, as rents on older leases are not true prices at all, and should definitely not be included in any price index. They are analogous to monthly payments on a mortgage.

I saw an article (that I can’t cite) which estimated that accounting for disguised rent cuts the actual rental rate is now falling at about a 5% rate. This means that while BLS data shows 1.7% core inflation, the true rate may well be negative. Indeed it is not obvious that the actual core inflation rate is any higher than the overall or “headline rate,” which was negative 1.4% over the past 12 months. Furthermore, it could get even worse, as the other major component in the core rate—the price of services—is closely related to wage rates. And wage inflation is now slowing sharply.

Why does any of this matter? In my recent debate with Lee Ohanian he made these assertions:

In contrast, I view deflation as less likely than inflation — in part because deflation would be so damaging that the Federal Reserve cannot afford to allow it to occur, and would adjust its policy accordingly.

. . .

At the end of the day, Federal Reserve policy has a large impact on whether deflation or inflation occurs, and given that the costs of deflation outweigh those of modest inflation, I expect the Fed will adjust policy to prevent significant deflation from occurring. The Fed’s moves have successfully done this over the last nine months, and would continue to do it if needed.

Professor Ohanian and I agreed on many points; we both saw Fed policy as determining the rate of inflation, and we both expected slightly over zero inflation going forward. The difference is that I thought that was too little inflation, and he thought it was about right. Thus I favored a more expansionary monetary policy, while he argued the economy did not need any more stimulus. But after seeing this core inflation data, I’m inclined to think we were both too optimistic. Contrary to what Ohanian asserted, it looks like the Fed has not successfully prevented deflation over the past nine months. If Ohanian believes that deflation would be “damaging” to the economy, and if he opposes monetary stimulus on the grounds that we have avoided deflation, then it certainly seems important to figure out whether we have in fact avoided deflation. Especially given that he has been a consultant to the Minneapolis Fed.

As my long-time readers know by now, I have always favored using NGDP as both an indicator and target of monetary policy. Indeed I would prefer NGDP even if inflation was measured precisely. But of course the inflation numbers that we work with, the numbers that eminent professors at Ivy League schools plug into their models, seem pretty much worthless to me. What exactly is the inflation rate trying to measure? In a world where goods are always changing, there is no obvious way to measure inflation. I suppose you could try to insist on some sort of utility-based concept, inflation as the rise in wages necessary to hold utility constant. But that would end up merely measuring wage inflation, as peoples’ expectations rise with every technological advance.

There is no perfect measure of inflation, only measures that are more or less convenient for various purposes. If I am interested in measuring the “cost of living,” I might want an inflation measure that includes rental equivalent. If I am interested in the damaging effects of deflation on the economy, I would not care at all about rents; rather I would be interested in the prices of new houses and apartment buildings. Why? Because if those prices fall sharply (even if rents are stable) then in a world of sticky wages the firms that build houses and apartments will dramatically reduce output. Thus deflation will cause a steep recession. And this will be true regardless of whether rents on existing apartments have risen or fallen.

In the end, I keep coming back to NGDP. It is something real, not a number dreamed up by a government statistician. (Well, even NGDP involves a bit of dreaming.) If the PC industry sells $34 billion in computers, then they sell $34 billion in computers. The inflation rate for PCs? Well, let’s see, I think that new Dell is 29% niftier than the old one, what do you think George?

If I wrote a macro book, I’d try to leave inflation and the price level out entirely. In the end, you might have to include it in the growth chapters, and perhaps exchange rates (for traded goods only), but nowhere else. The Fisher effect? I’d just use expected NGDP growth instead of expected inflation. BTW, this is why China isn’t even close to a liquidity trap despite deflation–check out their NGDP growth numbers. It is expected NGDP growth not expected inflation, which determines whether you will be in a liquidity trap.

My model of business cycles would use only two variables, NGDP and aggregate hours worked. After all, you can’t have RGDP if you don’t have inflation. Unemployment also seems too arbitrary. What’s the difference between “unemployed” and “discouraged worker” and “involuntarily part time?” Employment is more definite, but even that glosses over the full time/part time distinction. So I think total hours worked is best.

Then we’d need an AS/AD model. What would it look like without prices and RGDP? You could put AH (aggregate hours) on the horizontal axis, and actual minus expected NGDP on the vertical axis. There is no AD curve, and the AS curve crosses the horizontal axis at the point where the aggregate number of hours worked equals the natural rate. It has the normal positive slope, like any other AS curve. If NGDP exceeds expectations then AH exceeds the natural rate, and vice versa.

Or you could follow Earl Thompson and put average nominal wage rates on the vertical axis. In that case all you would have to do to is have monetary policy stabilize next period’s expected wage rate, perhaps with currency redeemable into futures contracts linked to the average wage rate next period. That would keep employment at its Walrasian equilibrium value, eliminating suboptimal business cycles. Productivity shocks could still impact RGDP, but remember we don’t have RGDP in our model, only AH. Hours worked should remain fairly stable, growing with population and changes in demand for leisure.

In 1982 Earl Thompson called it a perfect monetary system. I still don’t see anything better out there.

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