System of a Downer (Part 2)

Last week I wrote about using Systems Theory to describe the housing bubble. A key input to the system that created the bubble was the Federal Reserve’s (Fed) use on monetary policy to keep interest rates low. So this week I’ll use the same approach to describe how the Fed most likely botched it’s measurement of inflation in the housing market and used the resulting faulty inflation data and the “Everybody and his crack dealer should own their own home” politically driven mentality to keep interest rates artificially low.

I call this week’s PowerPoint catastrophe the “Monetary Policy/Inflation System”. You could call it the “Interest Rate System” or the “Bubble within a Bubble” or…. Oh, sorry, got a little carried away. Here’s the graphic:

Inflation, as covered brilliantly in a past post, is simply defined as too much money chasing too few goods. But inflation is tough to measure and that’s why handy indexes like the Consumer Price Index (CPI) are provided to us so that we can either jump for joy or shit our pants when we see said index fall to 1.2% or rise 56.5% (annualized of course). According to the Bureau of Labor Statistics (BLS) there are 9,108 basic components that make up the CPI. Everything from ‘Whiskey at home’ to ‘Intercity bus fare’ is included, but not home prices.

‘Home Prices’ as a category, per se, does not exist in the CPI. Instead, BLS uses ‘Owners’ equivalent rent of primary residence’ to measure the cost of homeowner occupied units. As proposed by Steven Gjerstad and Vernon Smith in a brilliant article in the Wall Street Journal (see ‘From Bubble to Depression?’)when the CPI’s measurement for home prices was changed to rental equivalence from direct home ownership costs back in 1983 the true cost of housing, as measured by the CPI, was thrown out of whack.

“So what?” you say, followed by a yawn. Well, that little adjustment to the way the cost of homeownership is measured, posit Gjerstad and Smith, caused overall inflation to be understated by 2.9% in 2004 alone (that would have put overall inflation for that year at 6.2% vs. 3.3% as recorded by CPI). Underwear still clean? From 1999 to 2006 the actual rate of inflation of homeownership costs was 151% vs. 23% as measured in the CPI component ‘Owners’ equivalent rent of primary residence’. Squirt!

This difference in the measurement of inflation had a huge systemic impact. When combined with a monetary policy driven by political goals of maximum employment, price stability, and maximized homeownership it effectively drove interest rates well below levels needed to contain an asset bubble. With interest rates artificially low the economy (GDP) grew at an unsustainable rate. GDP growth helped to employ more people who bought more homes through less reliable financing. This caused home prices to rise much faster than the generally acknowledged rate of inflation (CPI). Each cycle through this system created a larger gap between the real value of houses (market prices less inflation of 151%) and the value as measured by most indexes (market prices less inflation of 23%), which in turn, inflated the bubble a bit more.

This was a titanic game of musical chairs. When interest rates couldn’t be lowered any more the economic engine, fueling and being fueled by home prices, began to sputter. The cooling economy cooled home prices and lower home prices meant lower homeowner wealth. The wealth generated by soaring home prices had, for many, filled the gap in slower rising wages. This wealth effect helped grow the economy. Once this system began its downward spiral the impact to economy and homeowners dependent on the housing bubble wealth effect was nasty.
We’ll look at the nastiness next week.

Betcha can’t wait!

Later