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Inflation a Problem for Housing Recovery

Posted Tuesday, May 27, 2008

In spite of the sharp jump in the price of oil and other commodities, the core inflation rate has remained relatively mild at both the consumer level and the finished goods level in the Producer Price Index (PPI). This may be changing. The April PPI report released yesterday showed the core finished goods index rising by 0.4 percent. It has now risen at a 5.0 percent annual rate over the last quarter. There is much more inflation in the pipeline, with the core intermediate goods index rising 1.2 percent in April, brining the annual inflation rate in the core index to 12.4 percent over the last quarter.

None of this inflation is showing up at the consumer level yet, but this may be partially due to some anomalies in the data. For example, the hotel prices have been plunging at a 13.5 percent annual rate over the last quarter. Medical care prices are reported as rising at just a 1.6 percent annual rate over this period. Since we haven't seen any major reform of the health care system this year, such mild inflation is more likely a statistical anomaly than evidence of slowing in health care costs.

The inflation picture is important because relatively low mortgage rates have been the one important plus in the housing market. If higher inflation shows up in the core CPI, then it is likely to push long-term interest rates higher, including mortgage rates. If the mortgage rate were to rise to 6.5 - 7.0 percent it would still be low by historical standards, but it would be a serious blow to the housing market and to lenders who have recently issued mortgages at lower rates.
Even with rates under 6.0 percent (5.9 percent in the latest release from the Mortgage Bankers Association), demand appears to be weakening. The purchase index fell 6.9 percent to 352.5 in this week's report. Refinancing also fell. This is clearly not positive news, although with many applications now being turned down, it is not clear how changes in this index correspond to actual mortgage issuance.

Many commentators jumped on the April housing start data as positive news, as starts jumped by 8.2 percent from the March level. A closer look would take away the optimism. First, it is important to recognize that there was an unusually steep drop in starts reported in March, which was not fully reversed by the April uptick. Starts in April were still 6.8 percent below the February level. Second, the jump in April was entirely in multi-family units- starts of single-family units fell to the lowest level since January of 1991.

Of course, the decline in starts really should not be seen as bad news. This is a necessary part of the adjustment process after years of overbuilding. The sharper the fall in starts, the more quickly the housing sector will correct itself. 

It is worth noting that in the price tiers data of the Case-Shiller indexes, which show price movements by segments of the housing market, the lowest segment has taken the biggest hit in most markets.

For example, in the Washington, DC market, the overall index is down by 13.0 percent over the last year and was falling at a 26.8 percent annual rate over the last quarter. But for the low-priced homes (under $335,000), the declines have been 15.6 percent over the last year and 32.1 percent annual rate in the last three months. In San Diego, the price declines for the bottom tier (below $405,000) have been 27.5 percent over the last year and 36.3 percent annual rate for the last quarter. In Los Angeles, the drops in the lowest tier (below $434,000) have been 25.3 percent over the last year and a 43.1 percent annual rate over the last quarter.

Moderate-income homebuyers have taken an extremely hard hit over the last few years. In large parts of the country, the vast majority of recent moderate-income homebuyers are almost certainly living in homes that are worth far less than what they paid. 
By Dean Baker