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Why Inflation Appears Low   (June 2005)

Every small business owner and consumer has the queasy feeling that inflation is running considerably ahead of the "official" Consumer Price Index rate of 3%, but the misrepresentation (or manipulation, perhaps?) has been a puzzle--until now. Alan Abelson's column in Barrons this week contains a cogent explanation:
"Shelter, you see, which accounts for about 30% of the core CPI (and nearly a quarter of the overall index) is measured not by the dictates of the marketplace, how much houses actually fetch when they're sold, but by a strange -- make that perverse -- yardstick called owners' equivalent rent. Homeowners are asked how much they think they could get were they to rent their abodes.

The result, as Tony Crescenzi, chief bond market strategist for Miller Tabak, deftly puts it, is that "surging housing is suppressing the CPI." Rental income, he reports, has fallen to $147.8 billion, from the peak of $186.6 billion back in April 2002. "This weak pricing pressure in the rental market," he comments, "is weighing upon the owners' equivalent rent portion of the CPI" and, we might add, providing a distinctly distorted picture of what's happening in housing and inflation as a whole."
So the speculative buying of real estate which is driving up house prices everywhere has created a huge supply of property available for rent, lowering rents by 20% -25% nationally. This in turn suppresses the 30% of the CPI based on housing. 25% of 30% is 7.5%, which suggests that an accurate reading of the CPI over the past few years would be 7.5% higher--not even counting the added cost of second mortgages and re-fi's which homeowners have taken to draw out their equity. Despite the low interest rates, not everyone's mortgage has dropped; people are borrowing huge amounts against their equity--by some estimates, $1 trillion over the past few years.

Note that 35% of all home purchases nationally are second and third homes--pure speculation. Also note that 2/3 of the new mortgages in the San Francisco Bay Area are "interest only," which means the owners have deferred the actual costs for a few years. Finally, note that about 34% of all new mortgages and re-finances are adjustable loans, which means that the rates (and payments) will rise along with interest rates. Consider as well that even though low interest rates have made mortgages "affordable" (whatever that means), the tremendous rise in housing prices the past few years has dramatically raised the cost of buying a house--never mind the mortgage, how about the big increase in property taxes new buyers are paying?

Bottom line: inflation only appears tame, due to a quirk in the calculation of the CPI. The "real" rate of inflation is undoubtedly higher than the "official" rate of 3%. Consider the labor component of the economy, which Labor Department data reveals has started heating up:
"The new data show that hourly compensation in businesses outside farming rose 6.3% in the first quarter and 10.2% in the fourth quarter, both estimates substantially higher than previously reported 4.8% and 3.8% increases." (Wall Street Journal, 6/3/05)
Though the housing boom has skewed the data in favor of the status quo--borrow more, spend more, inflation is dead, long live speculative housing!-- it's doubtful the real rate of inflation can be masked for much longer. Then what happens? Perhaps what everyone fears--a rise in long-term rates and the deflation of the housing bubble.

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copyright © 2005 Charles Hugh Smith. All rights reserved in all media.

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