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Wednesday, May 08, 2013 2:20 PM

Hugely Negative Real Interest Rates Fuel Yet Another Housing Bubble; A Word About "Inflation" and Treasury Yields

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It's easy to spot a Fed-sponsored housing bubble if you look in the right places. The best place to start is an analysis of price inflation as measured by the BLS as compared to a CPI-variant that takes actual housing prices into consideration instead of rent.

This is a followup to my post Dissecting the Fed-Sponsored Housing Bubble; HPI-CPI Revisited; Real Housing Prices; Price Inflation Higher than Fed Admits.

Data for the following charts is courtesy of Lender Processing Services(LPS), Specifically the LPS Home Price Index (HPI).

The charts were produced by Doug Short at Advisor Perspectives. Anecdotes on the charts in light blue are by me.


The CPI does not track home prices per se, rather the CPI uses a concept called "Owners' Equivalent Rent" (OER) as a proxy for home prices.

The BLS determines OER from a measure of actual rental prices and also by asking homeowners the question “If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?

If you find that preposterous, I am sure you are not the only one. Regardless, rental prices are simply not a valid measure of home prices.

OER Weighting in CPI

click on any chart for sharper image

OER is now at 24.041% of CPI, which still rounds to 24.0%, but the other housing wedge is now an even 17.0%, down from 17.1% in the previous version.

The rest of the charts show various effects if one substitutes actual home prices as measured by the HPI in the data.

Two Inflation Indexes

click on any chart for sharper image

As measured by the CPI, price inflation is 1.47% annualized. As measured by HPI-substitution, price inflation is a much higher 3.33%. The Fed would have you believe everything is under control. Of course they said the same thing in 2005.

Real Interest Rates

Real interest rates are the difference between the Fed Funds rate and measures of inflation. The chart shows real interest rates as measured by the CPI vs real interest rates as measured by HPI-CPI. As measured by the CPI, real rates are -1.83%. As measured by the HPI-CPI real interest rates are-3.18%. For comparison purposes, real interest rate were -4.86 in mid-2004. The housing bubble burst one year later.

Fed Misses the Obvious

The above chart shows how much home prices as measured by HPI diverged from OER. And here we go again.

A Word About "Inflation" and Treasury Yields

This post is about "price inflation". It does not change my views on credit which I believe is headed for another bust. It also shows how hard it is to actually measure prices.

It's easy for the Fed to say everything is under control when it ignores everything important: housing, energy prices, education, and massive bubbles in the stock market, and junk bond market.

What about treasuries?

When the stock market and junk bond market bubbles burst, the Fed is as likely as not to go further out on the yield curve to suppress rates. Look for the Fed to keep doing the same thing over and over and over again.

Fools never learn as noted in a recap of the Fed Uncertainty Principle written April 3, 2008 before the Bernanke Fed started slashing rates in the Global Financial Crisis.

Fed Uncertainty Principle:The fed, by its very existence, has completely distorted the market via self reinforcing observer/participant feedback loops. Thus, it is fatally flawed logic to suggest the Fed is simply following the market, therefore the market is to blame for the Fed's actions. There would not be a Fed in a free market, and by implication there would not be observer/participant feedback loops either.

Corollary Number One:
The Fed has no idea where interest rates should be. Only a free market does. The Fed will be disingenuous about what it knows (nothing of use) and doesn't know (much more than it wants to admit), particularly in times of economic stress.

Corollary Number Two: The government/quasi-government body most responsible for creating this mess (the Fed), will attempt a big power grab, purportedly to fix whatever problems it creates. The bigger the mess it creates, the more power it will attempt to grab. Over time this leads to dangerously concentrated power into the hands of those who have already proven they do not know what they are doing.

Corollary Number Three:
Don't expect the Fed to learn from past mistakes. Instead, expect the Fed to repeat them with bigger and bigger doses of exactly what created the initial problem.

Corollary Number Four:
The Fed simply does not care whether its actions are illegal or not. The Fed is operating under the principle that it's easier to get forgiveness than permission. And forgiveness is just another means to the desired power grab it is seeking.
I don't care that much for treasuries here as I see no value, but that does not make them a good short. One look at Japan shows central bank sponsored low interest rate paradigms can last a lot longer than most think.

Mike "Mish" Shedlock

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