Why Don’t House Price Growth and Inflation Move in Tandem?

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Many may assume that rapidly rising house prices correspond with rapidly rising inflation for a given region. However, a recent Economic Synopses essay shows that the two aren’t necessarily linked.

Regional Economist Charles Gascon and Senior Research Associate Andrew Spewak noted that house price growth According to the Federal Housing Finance Agency house price index. from 2011 to 2015 was highest on the West Coast, where most metropolitan statistical areas (MSAs) saw growth of more than 2.5 percent.

Growth was slower throughout the rest of the country, but in total, 200 of the nation’s 381 MSAs saw house price growth of between 0 and 2.5 percent on an average annual basis.

“The general intuition is that, since housing is the largest expenditure for most households, variations in house prices should closely follow variations in the overall cost of living,” the authors wrote.

To examine a possible link between house price growth and regional inflation, the authors mapped MSA inflation rates. Using the implicit price deflator from the Bureau of Economic Analysis. The deflator is constructed by multiplying an area’s regional price parity (RPP, which measures an area’s cost of living as a percent of the national average) by the national rate of personal consumption expenditures (PCE) inflation. With three exceptions, average annual inflation rates over the same 2011-15 period were between 0 and 2.5 percent. That includes the West Coast, which had no MSAs outside that inflation range.

Gascon and Spewak focused on four reasons why regional house price growth does not measure regional inflation.

1. Housing as Shelter and Asset

The authors noted that house prices capture both the price of housing services (or shelter) and the value of housing as an asset. “The latter drives most of the change in house prices,” they wrote.

2. Little Change in Cost

They also explained that changes in house prices largely do not change the cost of housing. “According to the Census Bureau, 95 percent of homeowners remain in the same house from one year to the next,” Gascon and Spewak wrote. “For a non-mover household, the mortgage payment, by far the largest housing expenditure, generally does not change from one year to the next.”

3. House Prices and Renters

Next, they noted that changes in house prices don’t properly measure changes in costs for renters, which make up one-third of U.S. households.

They gave an example of a fast-growing MSA where new apartments are rapidly replacing older structures. The authors noted that rents would increase quickly in this scenario.

“However, rent prices would have changed anyway from one year to the next due to demographic shifts, property laws, and other reasons not related to the quality of housing,” Gascon and Spewak noted. “Thus, these rents reflect that renters are paying for a different kind of housing—higher quality or newer housing—and do not necessarily measure the actual inflation of rent costs.”

4. Substitution Effects

The authors also explained that households generally spend about 20 percent of their income on housing and this share is not sensitive to changes in prices.

“As prices rise, households respond by purchasing less or cheaper housing, keeping the housing expenditure weight constant,” they wrote. “It works the other way too: If prices decrease, households tend to buy more or costlier housing, again keeping the expenditure weight and inflation steady.”

To measure housing costs, Gascon and Spewak instead used rents from the Bureau of Economic Analysis, constructing an implicit rent deflator to measure changes in rents over time. The authors constructed the deflator by multiplying an area’s rent RPP by the weighted average of national rent PCE and national owner-imputed rent PCE, assuming one-third of households were renters. “These rents data measure only the cost of housing—for both owners and renters—instead of the value of the housing stock, and they adjust for the quality of housing, so they more accurately reflect what residents actually pay for housing.”

They found that rent growth was more evenly distributed across the country, with 351 of 381 MSAs seeing average annual rent growth of between 0 and 5 percent over the period 2011-15. The authors also found a strong correlation between rent growth and inflation.

“About half of the variation of growth in the implicit price deflator across MSAs can be explained by growth in the implicit rent deflator, consistent with our expectation that housing costs will drive inflation,” Gascon and Spewak wrote.

¹ According to the Federal Housing Finance Agency house price index.

² Using the implicit price deflator from the Bureau of Economic Analysis. The deflator is constructed by multiplying an area’s regional price parity (RPP, which measures an area’s cost of living as a percent of the national average) by the national rate of personal consumption expenditures (PCE) inflation.

³ The authors constructed the deflator by multiplying an area’s rent RPP by the weighted average of national rent PCE and national owner-imputed rent PCE, assuming one-third of households were renters.

• Economic Synopses: Warning: Don’t Infer Regional Inflation Differences from House Price Changes
• On the Economy: Housing Recoveries without Homeowners: A Global Perspective
• On the Economy: Monetary Policy and Regional Inflation