Updated on: 04/20/2022

It’s a common observation that generals and central bankers are always ready to fight the last war. A good example is the recent blog post from researchers at the Federal Reserve Bank of Dallas that has gotten a lot of attention by sounding the alarm about an overheated U.S. housing market. The report, which represents the opinions of the authors and is not an official Fed position, said housing is “becoming unhinged from fundamentals” due to “fear of missing out” by buyers leading to “expectations-driven explosive appreciation.” This will cause a “misallocation of economic resources, distorted investment patterns, individual bankruptcies and broad macroeconomic effects on growth and employment.”

The support for these claims is underwhelming, consisting of charts such as the one below showing the ratio of average home prices to rents in blue, with the authors’ opinion of what that ratio should be, based on economic fundamentals like disposable income per capital and long-term interest rates. The last time housing prices were this much higher than the model prices, there was a housing bubble.

A longer-term look at the housing price to rent ratio shows that it arguably predicted two of the housing downturns since 1975, but it also predicted three that did not happen. It also predicted two of the last six recessions but missed four and incorrectly predicted three others. It’s certainly worth paying attention to rapidly increasing housing prices given the damage of the last similar event, but not to issue sky-is-falling alarms. This tendency to fight the last war is just one of three dangerous tendencies common among central bankers.

The second is to assume there should be steady growth in prosperity, like the orange line in the chart. Real economies are dynamic and messy, with lots of booms and busts and sectors behaving differently. Averaging things together, such as all home sales and rents over a quarter, removes a lot of the detail and suggests that with some fancy statistics, ideal lines can be drawn on paper in ivory towers to criticize the real behavior of real people risking their own money.

Finally, central bankers are apt to ascribe failures of their models to defects in everyone else. The article uses polite terms like “exuberance” or “fear of missing out,” but a blunt way of putting it is, “People are stupid because they’re paying more for houses than our orange line recommends.” 

The problem with “people are stupid” explanations is not just that they’re usually false, it’s that you never learn. If housing prices diverge from the model, you should ask why. You may find that your model needs updating. If not, you’ll be able to point to the specific errors made by specific people, instead of one-size-fits-all expressions.

Here are some other ways to look at the data that suggest different conclusions. The price-to-rent ratio of housing is conceptually similar to the price-earnings ratio of stocks. Both go up in bubbles, but both can also go up if investors expect increased growth in rents/earnings or if investors lower their requirements for future returns. The chart below shows the home price to rent ratio since 1975 in blue (left axis) and the cyclically adjusted price to earnings ratio for the S&P 500 Index in orange (right axis).

In 1975 and 2000, there were run ups in the home price to rent ratio that were not matched in the stock market. But the increase in home price to rent ratio over the last 10 years, accelerating with the pandemic, does parallel the stock market. If anything, home buyers were slow to adjust. This suggests that the change relates to fundamental investment considerations and economic outlook, not anything specific to housing. If people are stupid, they seem to be stupid everywhere.

Another way to look at the home-price-to-rent ratio is to invert it and ask what amount of future rent inflation justifies current home prices. This can be compared to the “breakeven” inflation rate deduced from the yields on Treasury securities versus Treasury Inflation-Protected Securities, or TIPS. The chart below shows 10-year breakeven yields in blue, which can be thought loosely as the bond market’s expectation of average inflation over the next 10 years, and the rental inflation assumption implied by housing prices in orange.

The chart is misleading in the same way the Dallas Fed chart with the smooth model line is. Breakeven inflation can be measured precisely every day, with few assumptions. Breakeven rental inflation is measured with aggregated monthly data with errors, and requires assuming no changes in investor return expectation, taxes or other major factors. If we could measure it as accurately as we measure Treasury breakeven rates, it would doubtless have much more dramatic ups and downs.

But the chart makes the point that the large run up in housing prices can be explained by a plausible increase in assumed future rent inflation, from 2% to 2.3%. It’s true the last time that happened - in 2006 - market opinion changed so the rate went back down and housing prices crashed. That could happen this time as well. 

But it seems at least equally plausible that home buyers are correct in their assessments and long-term rental inflation will be a few tenths of a percent higher than had been assumed before the pandemic. Other plausible explanations are anticipated tax advantages of home ownership have gone up, increased immigration and regularization of immigrant status will increase demand for housing, working from home can shift resources from commuting and office space to increased residential space, land use restrictions will inflate housing prices, anti-landlord policies will push up rents -- among many others.

It's possible a few years from now the authors of the Dallas Fed report will be the subject of fawning interviews of “the prophets who predicted the housing crash.” But I hope their more thoughtful colleagues are looking beyond simple patterns in aggregated numbers to understand why buyers are paying more for houses, and what that means for economic policy.

Source: https://www.bloomberg.com/opinion/articles/2022-04-05/the-housing-market-is-hot-but-certainly-not-unhinged