Housing Disinflation, Fed's Ally In 2010

BIG PICTURE: Housing Disinflation Should Be Fed's Ally In 2010

By Kathleen Madigan

NEW YORK (Dow Jones)--Housing's collapse was a major headache for policymakers at the Federal Reserve as they tried to right the financial markets and keep the recession from turning into something worse.

But housing may prove to be a Fed ally next year. That's because the oversupply of homes should hold down core inflation even as the recovery leads to rising prices for other items.

Shelter accounts for a large 33.2% of the consumer price index--which makes sense since a mortgage or rent is a typical household's biggest expense. The share is even bigger within the core CPI, which excludes the volatile food and energy sectors and is the rate the Fed pays attention to.

Within the shelter category, the cost of homeownership--called owners' equivalent rent, or OER--makes up the biggest chunk. In CPI calculations, OER is not the actual mortgage but what a house would rent for in the open market.

During the housing boom, when vacancy rates were relatively low, OER inflation averaged 3.1%. The rate offset declines in other prices, including those for electronics, apparel and telecommunications. By 2006, OER helped to push core inflation close to 3%--higher than the Fed liked. Policy makers like to see inflation between 1% and 2%, centering around 1.5%.

But overbuilding and foreclosures added too much supply to housing markets, and vacancy rates soared starting in 2007. In the third quarter of 2009, the vacancy rate among homeowners stood at 2.6%, almost double its long-term average, while the rental vacancy rate rose to a record high 11.1%.

As a result, the amount a house would rent for barely moved and the OER eased sharply. In November, the 12-month increase in OER stood at only 0.8%, down from 2.3% a year earlier.

That slowdown came even though home prices have stopped their freefall, a welcome trend for household wealth and the mortgage-backed security market. Most of the stabilization is the result of better demand. Prices had fallen so low that investors re-entered the market. And a tax credit drew in first-time buyers.

But oversupply--and high vacancy rates--may hang around into 2010. Not only will rising unemployment mean more foreclosures, but builders keep breaking ground on new homes. In November, housing starts jumped a larger-than-expected 8.9%, to an annual rate of 574,000.

Guy LeBas of Janney Montgomery says, "So long as housing vacancies remain as high as they are, core inflation is nearly impossible."

That's because just as high housing inflation offset price declines in previous years, shelter disinflation will cancel out pricing power in other areas as economic growth picks up.

Mark Vitner of Wells Fargo Securities says core inflation has been "resilient" outside of the housing sector, and that the November CPI report showed notable increases in vehicles, airlines, medical care and tobacco. "Companies have done a very good job of shutting down inefficient capacity [and] boosting price power," he says.

But the Fed should be able to tolerate some of those price pressures as long as the imbalance within the housing market keeps core inflation near the central bank's comfort zone.

(Kathleen Madigan, a special writer, is the primary author of the Big Picture column. She has been writing about the economy for over two decades at BusinessWeek and Wall Street firms. She can be reached on +1 212 416 2466 or via email at: kathleen.madigan@dowjones.com.)