Fear of increasing inflation in the U.S. appear to be the trigger behind the market volatility of previous weeks. Recent gains in hourly compensation to workers have had analysts measuring the effect of wages on inflation. In turn, analysts began pondering changes in Fed’s monetary policy due to the apparent overheating path of the economy; which is believed to be mostly led by low unemployment rate and tight labor markets. Thus, within the broad measure of inflation, the piece that will help to complete the puzzle comes from housing market data. Although the item “Shelter” in Consumer Price Index was among the biggest increases for the month of January 2018, for technical definitions, its estimation does weight down the effect of housing prices over the CPI. Despite the strong argument on BLS’ imputation of Owner-Occupied Equivalent Rent, I consider relevant to take a closer look at the Shelter component of the CPI from a different perspective. That is, despite the apparent farfetched correlation between housing prices and market rents, it is worth visualizing how such correlation might hypothetically work and affect inflation. The first step in doing so is identifying the likely magnitude of the effect of house prices over the estimates and calculation of rent prices.
Given what we know so far about rent prices stickiness, Shelter cost estimation, and interest rates, the challenge in completing the puzzle consists of understanding the linking element between housing prices (which are considered capital goods instead of consumables) and inflation. Such link can be traced by looking at the relation between home prices and the price-to-rent ratio. In bridging the conceptual differences between capital goods (not measured in CPI) and consumables (measured in CPI) the Bureau of Labor Statistics forged a proxy for the amount a homeowner ought to pay if the house was rented instead: Owner-Occupied Equivalent Rent. This proxy hides the market value of the house by simply equaling nearby rent prices without controlling by house quality. Perhaps, Real Estate professional can shed light onto this matter.
The Setting Rent Prices by Brokers.
It is often said that rental prices do not move in the same direction as housing prices. Indeed, in an interview with Real Estate professional Hamilton Rodrigues from tr7re.com, he claimed that there is not such a relationship. Nonetheless, when asked about how he sets prices for newly rent properties, his answer hints at a link between housing prices and rent prices. Mr. Rodrigues’ estimates for rent prices equal either the average or the median of at least five “comparable” properties within a mile radius. The key word in Mr. Rodrigues statement is comparable. As a broker, he knows that rent prices go up if the value of the house goes up because of house improvements and remodeling. Those home improvements represent a deal-breaker from the observed stickiness of rent prices.
For the same reason, when a house gets an overhaul, one may expect a bump in rent price. That bump must reflect in CPI and inflation. I took Zillow’s data for December of 2017 for the fifty U.S. States, and run a simple linear OLS model. By modeling the Log of Price-to-Rent Ratio Index as a dependent outcome of housing prices -I believe- it will be feasible to infer an evident spillover of increasing house prices over current inflation expectations. The two independent variables are the Logs of House Price Index bottom tier and the Logs of House Prices Index top tier. I assume here that when a house gets an overhaul, it will switch from the bottom tier data set to the top tier data set.
Results and Conclusion.
The result table below shows the beta coefficients are consistent with what one might expect: the top tier index has a more substantial impact in the variation of the Price-to-Rent variable (estimated β₂= .12, and standardized β=.24, versus β=.06 for the Bottom tier). Hence, I would infer that overhauls might signal the link through which houses as a capital goods could affect consumption indexes (CPI and CEI). Once one has figured the effect of house prices on inflation, the picture of rising inflation nowadays will get clearer and more precise. By this means predictions on Fed tightening and accommodating policies will become more evident as well.