Cooling U.S. Inflation Fears With A Blast From The Garden Hose

Judging by the action in the financial markets, inflationary fears are en the upswing again, bolstered by some recent bad price numbers, rising investor interest in gold, and a pickup in the money supply. Yet new declines in such key variables as real wages and industrial commodity prices strongly suggest that such fears are excessive.

One development that supports a subdued inflation outlook, says economist Edward E. Yardeni of C.J. Lawrence Inc., is the behavior of existing home prices. "Such prices," he observes, "have an important impact on consumer perceptions and behavior."

Home prices were strong in the high-growth years of the mid-to-late 1980s, turned negative after the recession hit in 1990, and surged higher as housing starts paced the economic recovery in 1991. But since early last year, they have lost considerable steam, and at last count they were running a mere 1% over their year-earlier level (chart).

Because owner-occupied housing is the main asset of the middle class, notes Yardeni, home prices have a strong effect on consumers' willingness to spend. In the 1970s and the mid-1980s, surging home prices inspired many consumers to take on debt and spend with abandon. But today's homeowners are becoming increasingly aware that the value of their homes is failing to keep pace with inflation. As a result, "they are spending less, and when they do spend, they are more conscious of prices."

Weak home prices also promise to exert direct downward pressure on the consumer price index over the next year or so, claims economist Diane Swonk of First National Bank of Chicago. She notes that changing home prices are reflected in the CPI by the "owner equivalent rent" component, which alone accounts for some 20% of the index.

Owner equivalent rent is based largely on surveys of homeowners regarding the rents their homes would command if they were rented out. A major factor in homeowners' perceptions of rental rates, says Swonk, seems to be the value of their homes, and these perceptions tend to lag behind actual shifts in home values by about a year. While growth in median home prices peaked in 1989, for example, the owner equivalent rent component hit its high in 1990.

Similarly, after home prices slumped in 1990, the equivalent rent measure followed suit in 1991, and, aside from one uptick, has been trending even lower this year. With home prices still weak, Swonk says this key component will restrain the CPI for some time to come.

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