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As new money is created by the
banking system, it enters the price system as the recipients spend it. As the
prices of some goods rise, this should be captured in the CPI, right?
Not necesssarily. New money does
not impact all prices uniformly. And the CPI does not include all prices,
only consumer goods prices, and even then unevenly. If the effect of the new
money is mainly felt through financial assets or those consumption goods not
included in the CPI, then the CPI will not reflect impact of the new money on
prices.
Substitution can even reduce the
CPI. As money is created through the banking system by expanding credit,
credit-sensitive assets may at the same time increase in price and become
more affordable due to lower interest rates, so people may substitute
credit-sensitive purchases for cash-purchases. If certain goods are primarily
paid for in cash, their prices may even fall. If the falling prices are
included in the CPI, then the CPI may decline during an inflationary period.
And that is what's happening with housing.
Housing is a large component of
the CPI. The housing component of the CPI consists not of home prices, but of
"owner-equivalent rent", a measure of how much it would cost
home-owners to rent their home from themself. This rental input to the
computation is estimated from prices in the rental market. So, while home
prices doubled between 2000 and 2006, rents lagged because home ownership
increased relative to renting as the primary means of shelter. This had the
effect of keeping the CPI relatively low because the rapid increases in the
cost of home buying were not counted.
Barry Ritholtz has been following ongoing developments in the relationship
between the CPI and the rent/buy differential on his blog (see:
OER,
CPI and the Fed: A Strange Love Story
and
OER
/ CPI and New York Rentals).
The key points as Ritholtz explains are:
1.
Core
CPI is dominated by Owner's Equivalent Rent (OER).
2.
Existing
Home Sales in the NorthEast are outpacing the rest of the country.
3.
Existing
Home Sales in New York are far outpacing the NorthEast.
4.
Manhattan
Condos/Coops are far outpacing NY.
In summary, the owner-equivalent rent is slowing because of the
strength of the New York apartment market. This shows up as a lower CPI. The
Austrian Theory of the Business Cycle provides an explanation for how, in the
early stages of an inflationary boom, financial asset prices will tend to
rise while consumption good prices will remain stable. Because of New York's position as the leading financial center, financial asset price inflation tends
to show up as an increase in the incomes of people working in the financial
sector. That is what is driving the New York real estate market.
More inflation, lower CPI.
Robert Blumen
Robert Blumen is an independent
software developer based in San Francisco, California
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