The Great Inflation Moderation that Wasn't

Since a lot of people are talking about inflation and deflation this week and a lot of people have taken a liking to substituting the Case-Shiller Home Price Index for owners' equivalent rent in the Consumer Price Index as has been done around here for years now, maybe it's time for a little something different.

But first, before moving on, one last quick look back to the now-familiar graphic that shows how badly the Federal Reserve erred a few years back in thinking that "inflation" was either too low (2002-2003) or well-contained (2004-2005) and, advancing to the most recent data to the right, one measure of just how bad "deflation" is today.
As noted when these charts have appeared here previously, in addition to excluding other important homeownership costs such as taxes, insurance, and maintenance, this simple substitution has one other important flaw - it doesn't account for interest rates which, as anyone who has taken out a mortgage surely knows, are a very big factor in determining overall home ownership costs.

In fact, unless you own real estate outright, the first "I" in "PITI" is normally the single biggest component of what it costs to buy real estate.

I was going to say "own" real estate above instead of "buy", but you don't really own anything until you stop paying the "I", after you've whittled down the "P".

That doesn't seem to happen much anymore...

Anyway, plotting average 30-year mortgage rates against home prices is pretty easy. That is, after historical data for existing home prices was kindly sent my way a month or so ago.

There are no real surprises below - a big run-up in prices as interest rates were moving lower over the last 25 years with a major price correction at the end that still has a little way to go.
It is through lower mortgage rates that dimwitted economists have sought to rationalize the dramatic rise in home prices over the last few decades, most of them thinking that everything was hunky-dory right up until the housing bubble burst in 2005-2006.

But, as you can see below, after tracking each other closely through the mid-1980s, mortgage rates and mortgage payments then went their separate ways right up until the housing bubble burst when mortgage payments began reverting back to the historical relationship with mortgage rates, aided by plunging home prices.
Of course, you could say that it's not fair to only use the 30-year mortgage rate in these calculations since the wizards on Wall Street have come up with many innovative new ways to finance real estate purchases in recent years, all of which have made mortgage payments much more affordable (for a little while at least) despite the rising prices.

But, then you'd be an idiot.

Anyone could have done the simple math to calculate 90% loan-to-value and then gone ahead and fired up Karl's Mortgage Calculator to see that mortgage payments, when measured in the traditional manner, were going up dramatically as the housing bubble was inflating, something that, in an earlier era, would have been factored directly into the Consumer Price Index.

All of this brings us to the question of what it might look like if, instead of simply swapping out owners' equivalent rent for home prices, mortgage payments were used.

Since owners' equivalent rent wasn't created until 1983, about 11 years had to be lopped off of the charts above to generate what appears below, but it still shows what needs to be shown and, in the process, goes a long way in explaining why we are in such a big mess right now.
First and foremost, this measure of inflation with real homeownership costs included (no, this doesn't factor in taxes, insurance, or maintenance either, but they wouldn't make much of a difference) exhibits much wider swings than the "official" inflation statistics - as high as six percent and then dipping into negative territory on three occasions in 1986, 2001, and in 2008 with the most recent reading about the same as in the Case-Shiller version in the first chart above.

What's the significance of this?

Well, it seems as though the inflation aspect of "The Great Moderation" wasn't so moderate at all if you measure things the way they did back before 1983. Annual inflation rates swinging from zero percent to five percent in a year's time and from five percent back down to below zero are not something that any central banker would be proud of.

And since short-term and long-term interest rates track each other reasonably well over long periods of time, this is largely a result of central bank actions themselves in changing interest rates. It was as if the Federal Reserve was repeatedly whipsawing the economy with interest rate policy while missing important inflation data and not understanding the long-term damage that was being done in the process.

It's no coincidence that, after the events of the last eighteen months, very few now see what was once glowingly called the "Great Moderation" as a permanent shift.

As far as price signals go, it was more like the "Great Muffling".