Dispatch #23 – 2021
July 16th, 2021
This week’s Dispatch is going to focus on Inflation, to explain how rising rents will keep core-inflation high for longer. We’ll look at the composition of the CPI basket, what items are most heavily weighted and how price data is diverging from reality. Housing, the largest weight at 42%, is most distorted as the government’s Owners’ Equivalent Rent (OER) Index has not kept pace with house prices. Despite the cost of shelter only rising 2.6% year-over-year (YoY) in June, the headline CPI index came in hot, rising 5.4% YoY. In contrast, median home price data from the National Association of Realtors (NAR) jumped a record 23.6% YoY in May. Evidence points to an 18-month lag between housing prices and OER. Therefore, we should see rising OER keeping inflation high in the coming months, even as transitory items like used car prices (2.75% weight) ease. Longer term, though, the OER just hasn’t kept up with surging home prices, and it’s an ongoing distortion between real costs and government manufactured economic data. Here are this week’s discussion items:
- Inflation: June CPI came in hot, despite housing component remaining subdued
- Rising rents should keep inflation high as transitory items fade
- Elizabeth Warren’s letter to the SEC Chairman warns of crypto
- Super Mario cartridge sells for $1.5m – another investment asset!
- Bitcoin adoption news: Marshal Wace, BofA & Capital Group
Inflation: what CPI captures, what’s most important and the divergence
June headline CPI came in higher than expected at +5.4% year over year (YoY). This despite housing, the largest component with a 42% weight, rising a relatively modest 2.6% YoY. Let’s dig further into how the CPI index is calculated, as Fed officials continue to sing a transitory tune on inflation. Just note that Fed sets policy based on Personal Consumption Expenditure (PCE) index, but the CPI and PCE have a tight correlation. The Dispatch will focus on the more broadly followed CPI.
Housing is the dominant component of CPI
The chart above from Advisor Perspectives illustrates the importance of housing, which is 42.4% of the CPI basket. Housing is further divided into several components as the table below shows. Within “housing”, the largest component by far is “Owner’s equivalent rent..”, or OER. To calculate the OER index, the Bureau of Labor Statistics (BLS) takes the rent data from rental units and then massages to data to extrapolate the effective rent cost for the much larger number of owner occupied households. This BLS OER factsheet provides some color for anyone interested in more details. The Dispatch finds this Federal Reserve paper measuring rent inflation offers a clearer explanation.
Here’s BLS’ simple formula for calculating OER!
Leave it to the government to obfuscate with complexity. To their credit, the BLS publishes all of their methods. Many countries would not.
Source: BLS OER factsheet
OER accounts for nearly one quarter of the CPI basket, and it is an even higher weight in the core CPI Index that excludes food and energy prices. The Fed uses core pricing data to guide policy.
Components of the Housing Index
The scatter plot below of the May CPI data from research firm Variant Perception shows the outsized importance of OER relatively to the other large categories.
Source: Variant Perception
There is an 18-month lag between house prices and OER
Variant Perception also notes, as the charts below illustrate, that there’s an 18-month lag between OER and home prices. If this correlation persists, we should see inflation staying high even as used car prices and air fares ease. Used car prices have a 2.75% weight and airline fares just 0.63%. Rising OER could have an even larger impact on core CPI, which supposed to drive Fed policy.
Source: Variant Perception
Rents have lagged surging home prices over the longer term
Despite the Variant Perception observation above, OER has diverged over the longer term from rising home prices, as the chart below illustrates. The two data series is indexed to 100 at the end of 1982. One can ask who the heck is the BLS surveying? Or is this possibly what happens in an increasingly financialized world, where asset prices rally with structurally lower cashflow returns/yields. Zero percent interest rates will reduce the return homeowners seek. This is a good example of why interest rates can’t rise because it they will likely crush home prices as stagnant median wages won’t support rents rising. The Dispatch wish people would realize the low inflation mirage created by government CPI data. The housing market is exhibit 1 in that disconnect.
Source: St Louis Federal Reserve
This is what the nominal dollar chart of median home sale prices reported to the Fed looks like
Source: Federal Reserve
NAR Home price data is rising even faster
The snippet below is from the NAR’s most recent data release that shows home prices in May 2021 rose at a record 23.6% YoY pace. The highlights are by The Dispatch.
Housing affordability is dropping, which is no surprise
Evidence of sustained money printing that is justified by unrealistic inflation calculations are visible in many markets today. Housing is the most visible since it’s a basic human need and the largest household expenditure. The headline below from US News sums up the Fed-created condition on the ground. Many politicians continue to thank him for printing money to support consumption, but they fail to realize the negative consequences.
Source: US News
National Association of Realtors’ affordability index hit new low in May (low is less affordable)
Despite these notable signs of housing inflation, the “shelter” component of the CPI was up just 2.6% YoY in June 2021. The table below shows what components that contributed to the jump in June inflation.
June Inflation report by major component
Source: BLS June 2021 release
In conclusion, there’s a strong chance that inflation will remain elevated in the coming months as OER starts to pick up. However, the data above also shows that OER structurally understates the cost housing for homeowners, as the gap between home prices and OER widens. It’s one more example of how an economic measure, the CPI, is supressed to justify our current economic model of supporting growth at any cost.
This excellent historical perspective, from current Yale Professor and former Morgan Stanley and Fed economist Stephen Roach, talks about how the Fed botched tackling inflation in the 1970s and how it pushed to ignore food and energy by creating core-CPI concept. Of course, the core-CPI is even more heavily dominated by the rents. So, could the Fed, like they did in the 1970s, just ignore rent prices? Well, here’s a St Louis Fed article that argues just that!
What can consumers, investors or retirees do in the face of these distortions?
The Dispatch models higher inflation into retirement saving assumptions than what is frequently used by industry Monte Carlo Simulation models. We routinely see 2% inflation assumptions in models, whereas a more conservative rate for the next decade might be more than double that. The gap makes a significant difference in your retirement outcomes. Yes, demographics and technology are sources of structural deflation, but that does not preclude an extended period of high inflation as our money printing monetary policy experience continues apace. ESG too,is constraining capital allocation into energy intensive sectors, just as a new energy future requires more resources.
Elizabeth Warren warns of crypto and asks SEC for a response
Many politicians continue attack digital assets as they are a threat to the Fed’s ability to print money. Digital assets are a risk because those printed dollars will leak into scarce assets like bitcoin or ether that offers more utility. Government sanctioned money is a recent phenomenon in the fullness of history, which is a longer discussion for another time.
Super Mario 64 game sells for $1.5m
Central Bank manufactured liquidity is making assets out of formerly mundane items. As the Dispatch is fond of saying, most things are going up in fiat currency terms. This is just the latest, and there will be many other formerly mundane items reaching serious values. This BBC article provides more details of this auction.
Bitcoin and crypto adoption news
- Marshal Wace, the $50bn London based hedge fund, is expanding into digital asset investing. Read more on Blockworks.
- Bank of America established crypto research group within the research division. Read these articles from Coindesk and Bloomberg.
- Capital Group that manages funds worth $2.3tn reported a 12.2% stake in Microstrategy (MSTR) via Capital’s private equity arm. Microstrategy has invested heavily in bitcoin. The Dispatch wonders if the investment is for partners and employee capital. Nasdaq article has more details.
BITCOIN SCHOOL – Still on summer break
Stay safe and do reach out if you have any questions or comments about the material in this Dispatch.
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