home prices and inflation

David Leonhardt is the journalist to read about home prices.

But I've got a couple comments about his most recent contributions.

In this article Leonhardt is writing about the big, long-run uncertainties in the housing market.  He uses this to narrow his focus to fundamentals of demand and how demand changes with income.  If, as we grow richer, demand for homes grows faster than other kinds goods, then we may expect prices to rise a bit more than inflation, as they have in the past.  He draws interesting comparisons between homes and other kinds of goods.

My two main quibbles with all of this are:

(1) Supply matters too.  That is, the cost of building homes is likely to change as much as demand and income growth.  While it could go either way, building costs generally tend to decline, like everything else.  Bigger questions on the supply side have to do with congestion, transportation, where we work, etc., which ultimately drive the scarcity of land in places we want to live most.

(2) In the long run, supply and demand for housing ultimately drive rent.  But they don't necessarily drive home prices.  Or, at least rents, including expected future rents relative to other goods, are only part of it.  Prices also depend on how future rents are discounted to the present.

I think the second point must be on Leonardt's mind because he also just wrote a blog post seemingly arguing that interest rates don't have much to do with home prices.  Instead, he suggests psychology plays a role.  I'd argue that these two factors are not entirely separate.  The bubble probably got its start from low and persistently falling interest rates.  Then, perhaps, psychology took over.

It is important to account for the fact that home prices change slowly.  It's also important to account for anticipated inflation.  Most of the variation is Leonardt's plot of interest rates comes from changes in expected inflation.  This shouldn't have any real effect on home prices.  It's changes in real interest rates that matter most.  Real interest rates equal nominal rates minus expected inflation.

And then, we need to think about the fact that aggregate demand is an important factor driving inflation.  Thus, we often (but not always) see declining inflation and interest rates in times of declining demand (like today), and increasing inflation and interest rates in times of increasing demand.  So, in the 1980s interest rates were high because inflation was high, and inflation was high because demand was high.  So it wasn't so surprising to see home prices rising in a period of rising interest rates.  In contrast, during the big recent bubble, inflation expectations were pretty well anchored and interest rates were low and declining.  That is, real interest rates fell, and home prices boomed.

Anyway, I think Leonardt points out some interesting pieces here, but the larger uncertainties in the housing market have to do with inflation and interest rate expectations.  With disinflation and possible deflation looming, today's low prices and low interest rates are not the great deal they would be if inflation were expected to be in the old benchmark range of 2-3%.   Rents and prices for homes, like everything else, may fall further going forward.  Especially with housing, it's easy to see how this kind of deflation can lead to further contraction and recession.