Expect higher interest rates to beat delayed measured inflation

The government measures housing inflation indirectly and this indirect methodology makes a lot of sense in typical times, but has not produced reliable results in the crazy times of the past couple of years. The way that the government calculates housing inflation is not to measure the cost of directly buying a house or the carrying costs of that house, but by measuring rents. This owner equivilant rent measurement usually makes a decent amount of sense because basic economics (Frosh 101) argues that in the long run, rental housing and owned housing should have the same value, and rental housing tends to be more responsive to immediate conditions and therefore it is a good proxy for the total cost of housing.

However that relationship has broken down in the past couple of years as housing prices have skyrocketed but rents have stayed roughly the same in most markets. Again this makes sense — a lot of demand for owned housing means comparatively less demand for rented housing which means there is no price pressure on apartments. Therefore the OER metric would measure low housing inflation despite the fact that home prices have skyrocketed in the past couple of years.

This false measure would not be a big deal if OER contributed almost nothing to the CPI, but that is not the case. Calculated Risk links to a Marketwatch article that states 40% of the CPI index is linked to OER. This means that when the OER metric was delivering artificially low numbers due to the shift in demand from apartments to owned houses for the marginal consumer of housing choice, inflation was signifciantly understated.

Rents are projected by the NAR to increase by 5% this year. This means that OER alone will be pushing the CPI index up by at least 2% on its own. This is at the top end of a range that the Federal Reserve seems comfortable in seeing in overall inflation. And this top end range is from only one category in the index. We would need to see massive deflation in every other item that we buy (hi gasoline, hi college tuition, hi medical care, hi anything else that is in protected sectors) for the Fed to be happy with their inflation numbers.

I find that possibility extremely implausible. So I would expect either continued rate increases, or a fun redefinition of housing costs so that we can have no inflation if we exclude everything that is inflating (h/t to Barry at the Big Picturefor that phrase)

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