Economists say inflation not as bad - East Valley Tribune: Business

Economists say inflation not as bad

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Posted: Saturday, June 24, 2006 7:31 am | Updated: 2:06 pm, Fri Oct 7, 2011.

WASHINGTON - The Federal Reserve’s laser-like focus on inflation has investors parsing every scrap of pricing data that crosses their desks. The conclusion many have reached: Inflation isn’t as bad as the Fed seems to think it is.

Government data indicates that prices are on the march. Crude producer prices rose 2.0 percent in May, intermediate goods rose 1.1 percent, finished goods rose 0.2 percent. The year- over-year increase in the core Consumer Price Index, which is stripped of food and energy prices, was 2.4 percent.

Fed chairman Ben Bernanke has said any rate of inflation higher than 2 percent is outside his comfort zone.

But a closer look at the core CPI shows the largest factor behind its May increase was the cost of shelter. The largest component of the cost of shelter is a Bureau of Labor Statistics construction called ‘‘owners’ equivalent rent.’’ In May, owners’ equivalent rent was 30.3 percent of the core CPI.

If the increase in the cost of shelter, which includes utilities, were excluded from the core CPI, the year-overyear inflation rate would have been 1.9 percent in May 2006, down slightly from 2 percent in May 2005, according to an analysis by Bear Stearns & Co.

Has the cost of shelter been shooting skyward in recent months? Economists have their doubts. Owners’ equivalent rent has become a hot topic on Wall Street. One argument is that owners’ equivalent rent understated the cost of housing during the recent real estate boom and may be increasing now because the housing market is weakening.

The Bureau of Labor Statistics has used owners’ equivalent rent to calculate the cost of owning a house since 1983, when it replaced an index designed to represent mortgage carrying costs. The thinking behind the change was that owning a home is part shelter, part investment.

Owner’s equivalent rent computes what homeowners would pay to rent their housing. It’s based on a sample of rents with the estimated value of any utilities provided stripped out.

One problem: When the housing market was booming, the cost of buying a home escalated, but the cost of renting did not. It was a simple supply and demand equation, as the demand for homes from buyers was great, but the demand from renters was not.

Owners’ equivalent rent for 2004 increased 2.3 percent. But the price of buying a home in 2004 increased 11.17 percent, according to data from the Office of Federal Housing Enterprise Oversight.

‘‘At the time, we argued that the rental housing was in excess supply and owneroccupied housing was in excess demand and, therefore, to gross up rents to the entire housing stock was understating inflation,’’ John Ryding of Bear Stearns wrote recently.

Now, the equation has changed.

‘‘Since the first quarter of 2004, the rental vacancy rate has fallen from 10.4 percent to 9.5 percent and we think it is likely to continue falling further over the next year in the face of higher mortgage rates and elevated home prices,’’ Ryding wrote. At the same time, he noted, there’s an excess supply of housing for sale.

With so many condo conversions, the rental market has become tighter and rents are finally beginning to rise. At the same time, mortgage rates are creeping higher and housing prices have risen to unheard-of levels. Home affordability is now at a 20-year low, said Bernard Baumohl, executive director of The Economic Outlook Group and author of ‘‘The Secrets of Economic Indicators.’’

The demand for rentals increases as the economy slows because fewer people can afford to buy homes. Owners’ equivalent rent, he said, is an indicator that goes up as the economy starts to decelerate.

‘‘The last thing you want to do is raise rates strictly because owners equivalent rent picks up,’’ he said. ‘‘Then you’re raising rates simply because the economy is slowing.’’

There’s a possibility that the pick-up in owners’ equivalent rent ‘‘reflects evolving weakness in the housing sector,’’ wrote Ed McKelvey of Goldman Sachs Group Inc.

Another problem with owners’ equivalent rent is that most renters live in multifamily units, while most homeowners live in houses, McKelvey wrote.

‘‘While the Bureau of Labor Statistics goes to great lengths to sample rents on units as can be found to owner-occupied homes, one has to question the feasibility of measuring what OER is intended to capture,’’ McKelvey wrote. He went on to write, ‘‘It is ironic, to say the least, that an item that figures so prominently in household budgets is proxied by something nobody pays.’’

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