Tuesday, November 30, 2010

CPI - Confusing Price Index

I am fairly busy on the home and work front at the moment so not a lot of time for a new (meaningful) post.  I wanted to post a link to a wonderful John Mauldin essay recently dissecting US inflation data

I am working on a similar piece for the Australian CPI data - which I believe from initial research to even more severely understate price inflation than the US in its imputed/equivalent rent component.  Note that I personally consider any version of CPI to simply be one indicator of price inflation, and never exhaustive.  Moreover, the financial crisis has shown the need to move beyond a total reliance on consumer price inflation in determining monetary policy - in other words to also consider asset price inflation and (more importantly) monetary inflation (i.e. the supply and 'value' of money).
I quote the key passages in Mauldin's essay below, but the overall thrust of his argument is that by ignoring the cost of housing in terms of asset prices, and replacing it with an imputed rent version of the cost of housing, CPI data were depressed through throughout the last decade.  This (likely) contributed to the Fed's policy of keeping the cash rate so low in the early 2000's (and therefore the subsequent house price boom and bust). 

Powerful stuff!!

Mauldin starts by questioning the current suite of inflation data showing moderate positive inflation in the US, and then goes on to say:

...What if the way we measured inflation was flawed in some regard? Let's play a thought game. Back in the early '80s there was some consternation about using the price of houses as a way to calculate inflation. Read this paragraph from the BLS website (emphasis mine):

"Until the early 1980s, the CPI used what is called the asset price method to measure the change in the costs of owner-occupied housing. The asset price method treats the purchase of an asset, such as a house, as it does the purchase of any consumer good. Because the asset price method can lead to inappropriate results for goods that are purchased largely for investment reasons, the CPI implemented the rental equivalence approach to measuring price change for owner-occupied housing. It was implemented for the CPI-U in January 1983."

Homeowner equivalent rent is 25.2% of the input when they calculate the Consumer Price Index (CPI). Thus it makes a big difference how you calculate the price of housing. It is extraordinarily difficult to find historical data on homeowner equivalent rent in the BLS database. You can find "shelter costs," which include energy, insurance, etc. and are 41% of the CPI, but for our purposes today I want to focus more narrowly.

I did find an old release that shows the index value for the year 2000 to be 198.7 (http://www.bls.gov/cpi/cpid00av.pdf). The index value as of this October was 256.8. That means the rise in housing costs over the last decade was about 25% or roughly 2.5% a year, although in the last few years that number has gone deadline flat. And you can see that in the graph of total housing costs below.

CPI 10-Year Chart

But house prices went up by more than double that amount, and about 65% in the seven years from 2000 to 2007 (back-of-the-napkin estimate). That is an asset inflation of about 9-10% a year.

US House Price Index 1975-2010

What if we had been using actual home prices as the measure of inflation? Let's look at the year-over-year change in inflation for the last ten years:


Homeowners equivalent rent is 25% of the index. So take the home price rise, divide it by four, and add it to the inflation index. Inflation in the middle of the decade would have been running 4-5-6% and in 2005 would have been over 7%!

Would rates have been kept low "for an extended period of time" if we had still been using actual home prices? I rather doubt it - alarms bells would have been sounding. The Fed would have been leaning into the rise in "inflation." Thus no housing bubble would have developed. And then no credit crisis.  And the difference all stems from how you measure inflation. These details matter.


In the 1980s the BLS (under Reagan, so not a liberal plot!) decided a home was an investment and not a roof over our head. It also conveniently allowed for lower official inflation, which is what Social Security and other government programs are tied to. But that change had significant unintended consequences.

Monday, November 29, 2010

Persian Problems

Interesting analysis from Stratfor on the impact of the most recent wikileaks release of diplomatic cables.  While much of the media coverage has been on Arab neighbours urging the US to bomb Iran, the most interesting story at this point seems to be the open discussions of the Iranian's ability to fortify their nuclear facilities against conventional air attack. This prospect would be well known by the US and its allies, but the fact that this is being openly discussed arguably places even more pressure on the US to act quickly or else miss their 'window'. In a world focused on the Korean Peninsula, or European CDS, perhaps a bombing of Iran is the black (or is that grey?) swan we should be thinking about?


Sunday, November 14, 2010

Taleb on the Fed

Black Swan gold:

You may print, print, print and no effect. Just like a ketchup bottle you bang on with nothing coming out. And what can happen, is you keep banging on the ketchup bottle and it all comes out. This is the problem with non-linearity. The economics establishment isn't understanding that. Why are we listening to Bernanke when he didn't see the risks before? (1:20)

Australian Greens: Populism 1, Economic Credibility 0

Laurie Oakes interviewed Green's leader Bob Brown this morning.  Full transcript here.

We will amend any Government bill or else introduce our own discreet legislation to put a 24-month lid on the banks doing what they've done in the last week again. We think that they should be prevented from going beyond the Reserve Bank increases in the coming 24 months. Or if the Reserve Bank puts the interest rates down, they should be required to go at least as far down as the Reserve Bank...

...Let's make it for 24 months. It can be reviewed then. It's reasonable. I think Australians would welcome it. The banks are going to continue to flourish. But let them be tied to what the Reserve Bank judges as a fair and reasonable interest rate rise, or drop, in the coming 24 months. I challenge both the big parties to get behind the Greens this week in Parliament to put this in to law.

Kiss goodbye to any pretence of the Green's adopting responsible and credible economic policy as a 'balance of power' Party.  Preventing banks from setting the risk margin on loans for housing loans is the epitome of inefficient government intervention, and will have significant knock-on consequences (not least of which will be the transfer of net interest margin to other sectors of the economy such as SME lending).  Brown also shows extreme (deliberate?) ignorance in stating that the RBA decides what a "fair and reasonable interest rate rise" is.  What hogwash.


Update - just saw this potential legal assault on the banks variable margins for 'uncertainty'.  This might well be legally valid (indeed common sense would indicate it is), but again the consequences of this will simply be to require borrowers to be charged even HIGHER margins to compensate for the funding risk the banks run in funding a mortgage book.  This would be catastrophic for Australian banks whom are so dependent on offshore funding sources, and compound the withdrawal of lending in the already challenged Aussie housing market.

Saturday, November 13, 2010

The End of the Fed

Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.
       -  Winston Churchill, 1942

Winston Churchill's famous words might well apply to the US Federal Reserve.  Or at least the Tea Party, contrarian traders, libertarians and gold bugs would have us believe this is the case.

There is a lot of chatter on blogs and in trading rooms in New York about the imminent appointment of Ron Paul to the House Committee on Domestic Monetary Policy.  For those who are not au fait with Ron Paul, a recent article in Vanity Fair provides a good summary of Paul's political history.  The mere existence of such an article in Vanity Fair however, says even more about how mainstream Paul's ideas about fiat money, libertarianism and constitutional interpretation have become.

The irony of the author of "End the Fed" becoming one of the major legislative overseers of the Fed has not been lost on the mainstream media either.  See this recent story in CNN for example.

Paul has been coy in talking about how he will use leadership of this committee to push his agenda, but it is clear that he will at a minimum make life tough for the Fed (and Bernanke in particular) and uncover a range of practices that are currently poorly understood by the markets and the general public (for example the international swap lines the Fed has in place with Central Banks of other nations).   It is widely thought that Bernanke's testimony to the same House Committee in 2009 will be raised again (at least for rhetorical purposes).  In this testimony Bernanke provided an answer to another member of Congress from Texas in which he said "the Fed will not monetize the debt" (which of course is exactly what many critics claim QE2 is now doing).  Look at 48mins on the video below at this link on c-spam.

This blogger thinks developments in this area are of paramount importance to how 2011 will play out - probably even more important than the fiscal compromises arrived at in Congress.   There are a handful of 'triggers' one could see causing things to take an unexpected turn next year - this is one of them.  At a minimum it is going to make QE3 harder than some might currently be assuming is the case.

Lies, Damned Lies and Housing Statistics 2

I promise this is a more succint post than the last one!  Interesting to see that the REIV had to 'revise' the paltry Melbourne auction clearance rates last week because a number of agents had failed to report 'unsuccessful' results.  This highlights the flaw with so much of Australia's housing statistics - they are dependent on real estate agent voluntary reporting of information.  It's like asking a punter to determine the photo finish of a horse race!

In a similar vein I could only laugh at Brisbane's auction results today.  Reporting a clearance rate of 8% (or 2 properties sold out of the 21 auctioned), one property sold for $930k prior to auction (denoted "SP"), and the other is denoted "SN" indicated sold prior, price undisclosed.  Why would you try to sell a house in Brisbane via an auction on these numbers... but perhaps more importantly why would anyone have faith in any of these statistics?

Thursday, November 4, 2010

Lies, Damned Lies, and Housing Statistics

            Get your facts first, then you can distort them as you please.
                -  Mark Twain
The Great Affordability Swindle

House price to income ratios may seem a bit dry for a first post.  Nevertheless I would ask that you bear with me as I discuss one of the cornerstones of understanding Australia's housing market.  After much discussion over the last few years, the Australian housing market bubble debate took a seriously weird turn when attention turned to debating the merits of competing 'price to income' ratio methodologies.  Even if you are not an egg-head interested in economic data, this analysis is interesting...and scary!

For many years the debate about Australia's unaffordable housing market raged.   We will spend lots of time going through these various arguments in future posts (you know the drill: housing shortage, high population growth, cultural affinity to property, strong banking sector, etc etc).  The argument about 'bubbles' is largely about affordability though. 
Those who are convinced there is a property bubble in Australia will often point to our house price to income ratio as evidence that prices are reaching an unsustainable levels and are due to correct (i.e. reduce).  In simple terms this ratio is defined as:
Price to Income Ratio = Median House Price / Median Disposable Household Income
One way of interpreting this is how many years it would take (with no other expenses) to save for a 'middle of the road' house with a 'middle of the road' income.  Sounds like a sensible test for affordability, right?
Demographia Data
One of the most helpful sources for this information in recent years has been Demographia (http://www.demographia.com/dhi.pdf).  Their annual survey publishes 'median multiples' across urban areas in the US, UK, Ireland, Australia, Canada and New Zealand.  To be clear, the survey looks at both median 'price' and 'income' levels for major urban areas in all of these six comparable developed nations, and generates a ratio of median price/income for each.  The higher the 'median multiple' in a given city, the more unaffordable it is.
Over recent years the preponderance of Australian cities in this survey among the most 'severely unaffordable' has been given considerable media coverage (if for no reason than the Australian media's unending ability to sell papers when anyone discusses the question of whether house prices are over-valued!).  The 2010 Demographia survey was the most scathing yet of the level of affordability in Australia, and was used by a number of commentators and investors to justify their highly publicized views that Australia's housing market is overvalued.  The top ten most unaffordable cities according to the 2010 survey were:

To rub salt into the wound of Australia's housing market supporters, the survey also summarized the results of its survey by country as follows:
The conclusion of this survey is that only one of twenty-three major urban real estate markets in Australia is not 'severely unaffordable' according to Demographia's methodology, and that market is still 'seriously unaffordable'.  This level of unaffordability massively exceeds any of the other nations in the survey.

Other Median Multiple Data

Other commentators, such as GMO founder and chief investment officer Jeremy Grantham, have made a lot of headlines quoting price-income ratios which, while lower than Demographia, are still much higher than historical levels and much higher than the levels seen in other nations.

Gratham has been quoted as saying: "The price of housing typically trades about 3.5 times of family income and in bubble it goes to 6 or.. 7.5 (times)”... "you are at near 7.5 times family income... which suggests you are twice the size that you should be." (The Australian, 16 June 2010)

The main difference between Grantham's numbers and Demogaphia's appear to be Grantham's use of median price for all dwellings as the numerator in the ratio, wheras Demographia appear to use house prices only,  which is a material difference. 

Nevertheless the result of both Demographia and Grantham's numbers are the same: a clear indication of the historically stretched valuations being ascribed to Australian houses.

The Empire Fights Back
Unhappy with these turn of events, and even more unhappy with a simple and straightforward comparison to international affordability metrics, the Australian property lobby fought back.  For many years the mouthpieces of the property lobby were content in relying on the 'stock vs flow' argument for why such damning data was irrelevant.  In other words, the idea that any comparison of a stock (house prices) with a flow (income) was bound to be inaccurate.  A related argument against such 'crude' measures of affordability was the idea that the level of mortgage repayments (driven by interest rates) are more important than the level of price and income themselves.  I will address these propositions in a future post, but to preview, this argument is only reasonable if one considers long term interest rates, not current interest rates - after all it is a 30 year mortgage!  Suffice it to say that many people could see through the chimera.  Thus, the property lobby had to attack the affordability ratio itself and find away to make it more pliable to their tale.
Bullish property commentators such as Christopher Joye realized that Demographia and virtually everyone that was tracking affordability was using Australian Bureau of Statistics survey data for the 'median household income' portion of the affordability ratio discussed above.  So they uncovered a 'better' source for household income: the national accounts used to calculate GDP.  As described in this post, Joye claims the national accounts defnitition of household income is better for two reasons: 1) the household survey data is "dated" being a 2007 study whereas National Accounts data is released in a much more timely fasion; and 2) "earnings on savings and investments" should be included because "people buy homes out of disposable incomes rather than wages".
As I note below these are somewhat spurious reasons to use the National Accounts data as 1) it is very easy to adjust the 2007 numbers for subsequent wage/income growth (as I do below) and 2) there are a number of sources of 'disposable income' in the national accounts which contratary to Joye's post are not actually available for people to "buy homes" (such as superannuation contributions and 'imputed' rental income).  More on that below too.

To cut a long story short, the numbers that Joye used imply that the ratio of house prices to incomes is actually closer to 4 to 5x which - surprise, surprise - is in line with other developed nations.  The most recent incarnation of this logic has been recently updated by Joye here and here, which provides a useful snapshot of the way in which this 'modified ratio' is being used as a debating weapon.  I examine the different numbers below, but the short answer on how a ~50% reduction in the affordability ratio is conjured up is that they 'find' additional disposable household income of over $20,000 compared to the ABS survey data.  Oh, and they use the average household income rather than the median which is worth about another $12,000 in annual income (because the highest income earners 'drag up' the average).  The 4-5x ratio implies that the disposable household income that should be compared with the median house price, across Australia, is ~$95,000.  This is the after tax level of household income.  With 25% effective tax rate this implies a gross income of $125,000 is what the 'median' household earns in income that can be spent on bills, food and mortgage payments. 
These numbers have been picked up by all the usual suspects wishing to argue that the affordability problem is, err, not really a problem.  Once the RBA started using this data it was on for young and old, including the big four banks who have begun parroting these same ratios in their presentations, shamelessly using them to 'alter' the unfavorable international comparisons applied to the asset class that chokes their balance sheets and income statements - residential property lending.
Westpac's effort here (pages 8 and 9, and chart 7, in particular).
CBA's effort here.
The CBA's alteration of the international affordability comparisons was perhaps the most clumsy and crude, but you have to give them marks for being brazen!  Note that my comments to the right were not in the CBA's charts released to investors, showing that they adjusted the Australian numbers but not the international comparisons.  For more background on this cheeky effort, see this Steve Keen post which picked up on Kris Sayce's initial discovery of this chimera in his Money Morning blog.
Decoding the Numbers
All of this begs the obvious question: how can two official measures of household income be so different?  Before providing a quick reconciliation of the numbers, here's what they are.
a) The ABS median household income survey

The most recent ABS household income survey was conducted in 2007/2008 and can be downloaded here.  Details of the methodology employed by the ABS in this survey can be found here.

In summary the ABS data involves a survey of individuals living in dwellings, and counts income that as a general rule is "available for consu mption" - in other words cash or cash like in nature and available to meet cash obligations.   

b) The national accounts household income data
The national accounts data is essentially designed to count all economic production and activity in every given period in order to calculate (among many other things) GNP and GDP.  These sources of economic activity are in many cases non cash sources of income to household, or otherwise unavailable to be actually spent.

In using this data to come up with a measure of 'household income' the banks have divided the aggregate proportion of Australia's GDP apportioned to the Household Sector in the national accounts by the total number of households according to the ABS.
c) Bridging the gap

The ABS published the following statement as part of its 2007/2008 household income survey:

The concepts of income used in SIH have many similarities to the household income definition used in the Australian System of National Accounts (ASNA), but also differ in some respects. A detailed comparison of 1997–98 SIH and ASNA estimates was published as an appendix to the 1997–98 issue of Income Distribution, Australia, 1997–98 (cat. no. 6523.0). Comparison of SIH data from 1994–95 to 2007–08 with ASNA data indicated that the relationship between the two estimates had not changed significantly over that period. [Link Added - from page 55]
I have used this 1997 reconciliation between the national accounts data and the household income survey to provide a bridge between the two sets of numbers.  I happily accept these are somewhat 'rounded' numbers, but the ABS has specifically noted that the relationship "had not changed significantly over the period", so this should provide a reasonable estimate.  My approach has been to take the 1997 reconciliation and scale the adjustments to the 2008 household income numbers discussed above. 

Before diving into the details, it should be noted up front that the National Accounts data showed 57% higher household (gross) income in 1997 than what was indicated by the ABS household survey.  So to be clear the order of magnitude of the difference seems to be about the same.

One additional adjustment that must be noted is that the national accounts numbers implicitly use an average household income measure, rather than a median.  This is clearly inappropriate in the context of a median house price to income ratio, and so the scale of this adjustment is estimated also using the difference between average and median incomes in the ABS household survey (which should be highly comparable).  I have also grossed up the 2008 figures to 2010 to also aid the comparability (i.e. helping the case of the housing bulls and addressing one of the original reasonse the banks etc gave for using national income data rather than household survey data).

Here is the summary of my analysis:

So what does this analysis tell us?  All of the differences between the higher income number used by the banking sector to support a lower price to income ratio are, in my opinion, very difficult to justify as being useful in an affordability metric.  For example how does the imputed rent of owner occupied homes provide any capacity to afford more expensive house prices?  The inclusion of implied income received from higher housing costs itself seems very ponzi-like, without even looking deeply into the calculation of imputed rent.  Or consider superannuation contributions (the other major difference).  How do superannuation payments, locked up until retirement to fund consumption, facilitate paying higher prices and mortgage payments for a home before retirement?  Perhaps the most egregious difference is the first one highlighted above - the national accounts definition of 'households' include private non-profit organisations like churches and clubs which have nothing to do with actual household's ability to affod their homes and mortgages!!

Finally, the whole purpose of calculating a price-income ratio is to provide some long term benchmark to assess how affordable housing is relative to historical trends, and to enable international comparisons.  The argument made by the banks in lowering the ratio by using the highest possible income figure does nothing to refute the unaffordable nature of current prices relative to historical measures of the Australian price-income ratio.  While the banks argue there are structural reasons for this (esp a lower interest rate environment), this is a very different argument to saying that the ratio is not currently high.  As for international comparisons, this blog has not conducted an in-depth study of the income measures used in surveys such as the Demographia study.  It seems unlikely, however, that relatively obtuse national accounts data would be used to estimate income in the US, UK, Ireland, NZ and Canada, when all of these nations also publish timely household income surveys (I have asked Demographia the question but no response yet). 

Don't Believe the Hype
Based on the above, this blogger thinks the following statements are irrefutable:
- Australian house prices are considerably higher (relative to our incomes) than other developed countries
- Australian house prices are at an historically high multiple of income (however measured), and this increase has particularly occurred over the last 15 years.
- The use of the modified affordability multiple by the banks and several prominent housing industry advocates is at best inaccurate, and appears to paint the rosiest picture possible of the state of the market.   This is not only because of logical flaws in the use of national accounts income as the denominator in an affordability ratio, but equally importantly because of the modified ratio's inappropriate use in international comparisons.
Padding the numbers in this way might make for pretty slides and graphs in bank presentations, but it exposes a degree of delusion and desperation that is truly scary.

And I believe it is misleading.