Weekly Inflation Outlook: An Antacid For My Headache

This week, we will again get several opportunities to reconsider the received wisdom that when mortgage rates rise, home prices must fall. Last week, median home prices in the Existing Home Sales report were reported to have declined about -1.5% month-on-month (mom) on a seasonally adjusted basis (I had to eyeball the seasonal because they don’t report a seasonally adjusted figure).

Prices have fallen over the past two months, although some of that is seasonally normal. The data on Tuesday will be higher quality data from July (S&P CoreLogic Case-Shiller data) which is expected to show a small gain of 0.2% mom. Home prices have definitely come off the boil and are declining in some precincts.

But it’s a little hard to tell yet how much of that is merely exaggerated late-summer seasonality, how much is distressed sellers hitting bids, and how much is a move lower of the true equilibrium nominal price. Because we are also seeing stories like this one from Redfin last week:

The 'New Weird' in this case is that home prices are falling in real terms but not in nominal terms. That’s actually not weird at all. According to the story, confirmed by lots of other reports, “there’s very little new supply hitting the market,” which means that even though there are fewer buyers because of the increased mortgage rates, there are also fewer sellers.

There’s literally nothing magical about higher mortgage rates causing lower prices, at least in the short run. Each buyer, to be sure, has a ‘loss’ because he’s paying a higher mortgage rate than a few months ago. But each seller is sitting on an equal gain if they have a fixed-rate mortgage, which is now better than the market. A home buyer, after all, is buying an asset and ‘issuing a bond’ (agreeing to a mortgage) to pay for it. The home seller is divesting from the asset and redeeming the 'bond' he previously issued, at par. Except that now that interest rates have gone up, that 'bond' is trading at a discount so that redeeming it at par represents a loss to the home seller (and, importantly, a non-taxable loss since the IRS doesn’t recognize this as a bond transaction).

This is different from certain other countries where floating rate mortgages are a lot more common than they are here. Obviously, a home seller who has a floating rate mortgage is not facing the loss on his lower-than-market interest rate and is probably more likely to sell.

The bigger-picture issue, though, I have discussed before and that’s that thinking that a correction in home prices should happen in nominal space when in fact it should happen in real space. Why are homeowners not selling? Gosh, I have no idea…maybe because they own a real asset financed by a nominal dollar loan in an inflating economy? In that environment, the only sellers aggressively hitting bids are ones who are forced to by circumstances. So, indices may decline if there’s a selection bias to favor desperate sellers more than desperate buyers, but I don’t think they’ll decline very much.

Taking a Step Back...

Global central banks are slamming on the interest rate brakes in a way unlike they have in decades. I continue to repeat my mea culpa that I totally didn’t expect they would.

It’s also, I keep repeating, the wrong medicine. The money supply is 40% higher than it was before the crisis and prices are 15% higher. That spread needs to close and if the Fed isn’t aggressively shrinking the money supply, prices will continue to rise until that gap equals the total growth in the real economy over that period.

I keep trying to come up with ways to convince people that the aggressiveness of the Fed most certainly should impact liquid asset prices but it isn’t clear if it should have much impact on inflation. Here is my latest:

• It took years of zero rates—if low interest rates are what causes inflation—to get inflation. If rates are the answer, then, shouldn’t it take years to get disinflation?
• On the other hand, it took mere months of explosive money growth to cause inflation. If money is what matters, we could change the price level quickly by changing the money supply.

I’m not saying that the Fed shouldn’t raise rates or, rather, simply allow interest rates to find their free-market level rather than holding them artificially low. Of course, they should. What I’m saying is that that medicine is treating the asset-price problem, not the consumer-price problem. If you have a headache and take an antacid, then it still has an effect. It just doesn’t fix your headache.

Disclosure: My company and/or funds and accounts we manage have positions in inflation-indexed bonds and various commodity and financial futures products and ETFs, that may be mentioned from time to time in this column.