Crescenzi on Credit
How Housing's Surge Is Suppressing CPI
 By Tony Crescenzi
RealMoney.com Contributor

5/18/2005 12:59 PM EDT
URL: http://www.thestreet.com/p/rmoney/crescenzioncredit/10224145.html
 Economic Analysis
  • Core consumer prices were unchanged in April, thanks largely to the strong housing component.
  • Surging demand for housing seems to keep reducing demand for rental units.
  • The CPI could turn if the housing market turns lower.
    		•

    Core consumer prices were flat in April compared with March, the first unchanged reading since November 2003 and two-tenths of a percentage point lower than expected. April marked only the fifth time in 22 years that the core prices were unchanged. (Prices haven't fallen since December 1982.) April's benign reading followed an unusually large gain of 0.4% in March, which was the largest gain since August 2002.

    In light of the unusually large gain posted in March and the equally unusually benign reading in April, it is probably best to combine the two months, as both are outliers. Core consumer prices, therefore, appear to be trending with gains of about 0.2% per month or perhaps more in light of the 2.7% annualized gain seen so far this year.

    A Flip-Flop From March

    April's benign reading partly reflects a flip-flop of price increases seen in March. For example, lodging away from the home rose an unusually large 3.9% in March but fell 1.2% in April. Gains in this category have averaged 0.6% per month in the past year. Apparel prices rose 0.8% in March (prices tend to be flat or lower) but fell 0.6% in April. Medical costs rose just 0.2% after rising 0.5% in March (gains tend to average about 0.4% per month).

    The Federal Reserve is likely to analyze the April CPI in the context of the March CPI and hence draw no inferences from each individual month. The PCE deflator remains the key inflation gauge to watch. Trends in labor costs also will weigh heavily at the Fed.

    Housing Market Soars, Knocking Rents Lower

    Importantly, the housing component continues to weigh on consumer prices. Owners' equivalent rent (OER), which measures the amount of money that homeowners believe they could get for their homes if they rented them, accounts for 23% of the overall CPI and about 30% of core prices. OER rose just 0.1% in April, half its usual gain.

    Surging housing demand appears to be continuing to reduce demand for rental units, weighing on the OER component of the CPI. Strength in housing demand is apparent in the recent data on mortgage applications for home purchases, wherein the four-week moving average is now at a record high, as well as the National Association of Homebuilders' latest housing market index, which in May reached its second-highest reading in five years. Meanwhile, rental income has fallen to about $147.8 billion from the peak of $186.6 billion in April 2002. When the housing market weakens, it will result in increased demand for rental units, hence boosting the OER portion of the CPI.

    So the message in all of this is to understand the perverse logic of how the strong housing market is influencing the CPI and how it could turn if -- a big if at that -- the housing market turns lower.

    The Fed's Take on Housing and the CPI

    Below is an excerpt from a 52-page study conducted by the Fed last April discussing the impact of housing demand on the OER component of the consumer price index:

    Downward pressure on rental prices mainly resulted from an increase in demand for homeownership, which was spurred by historically low mortgage interest rates (see Figure 19). As housing starts and home sales surged in the recent recession and recovery, the national rental vacancy rate jumped from 7.8 percent in the fourth quarter of 2000 to 10.2 percent in the fourth quarter of 2003. This effect was compounded by the way owner-occupied housing prices are measured in the CPI. The CPI uses a rental-equivalence approach, measuring the value of the shelter services an owner receives from his or her home. Price movements in owners' equivalent rent reflect changes in prices of rental units that are comparable in characteristics to owner-occupied homes. Therefore, increased demand for homeownership put downward pressure not only on tenants' rent but also on owners' equivalent rent -- the largest component in the CPI.

    The chart below, "Figure 19" referenced by the Fed above, helps highlight the impact. Note that when mortgage rates go up, demand for new homes presumably falls, hence boosting the demand for rental units and thus boosting rental costs and the CPI.


    Source: Federal Reserve
    Tony Crescenzi is the chief bond market strategist at Miller Tabak + Co., LLC, and advises many of the nation's top institutional investors on issues related to the bond market, the economy and other macro-related issues. At the request of the Federal Reserve, Crescenzi is a regular participant in the board's Livingston Survey of economic forecasters. He is also the author of The Strategic Bond Investor. At the time of publication, Crescenzi or Miller Tabak had no positions in the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Crescenzi also is the founder of Bondtalk.com, a popular Web site covering the bond market and the economy. Crescenzi appreciates your feedback; click here to send him an email.

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