House prices and inflation
MAY 16, 2011
Examining fundamentals:
This will be the last post examining the fundamentals that underpin real estate across Canada. Later this week, I hope to compile all the data we've examined thus far into a sort of comprehensive overview of the Canadian housing market....an über primer if you will.
As a refresher, here is some of the data we've examined thus far:
House prices and economic growth (part 1 and part 2)
House prices and income growth (part 1 and part 2)
House prices and population growth.
House prices and rents.
The potential economic/employment impacts of a housing bust (Part 1 and part 2...also check out home renovations as a percent of GDP)
Today we turn our attention to house prices and inflation.
Why inflation matters
It was bubble guru and Yale economist Robert Shiller who famously calculated that house prices in the US have done little more than pace inflation over the past century.
In fact, the most extensive historic housing data set in the entire world verifies this finding. Price data for the Herengracht Canal in Amsterdam extends all the way back to the early 1600s. Remarkably, real (inflation-adjusted) house prices have moved around a long-term trend line over the past 350 years. That is to say that houses essentially pace inflation over time. Source: Piet Eichholtz as cited by Steve Keen
Note that periods of under performance relative to inflation were eventually corrected with rapid moves to the upside, while periods of over performance relative to inflation resulted in an eventual correction to the down side. Note however that this can happen via a reduction in house prices or a stagnation in house prices while inflation catches up (the 'soft landing' thesis, if you will). Finally, note that periods of outperformance and underperformance in house prices can be stable over periods of decades before finally finding their long-term equilibrium.
The degree to which house prices are influenced by inflation is debated among economists. While the very long-term trends show a stable relationship, the divergence between the two variables can be long-lasting and significant, leading some to question whether inflation is a worthwhile predictor of house price movements. However, it should be evident that as materials, land, and labour costs rise, new house prices will rise accordingly, raising the comparable value of all homes as replacement costs rise. Conversely, outsized gains in real estate values relative to inflation may indicate that house prices have gotten ahead of themselves. So while the growth in inflation and house prices may or may not be an indicator of near-term movements in house prices, we would be remiss to not at least explore the long-term performance of the two variables in Canada.
Here in Canada, inflation is often measured using the Consumer Price Index which tracks changes in a basket of consumer goods. For those not familiar with the Consumer Price Index, here's a brief overview courtesy of Stats Canada:
The Consumer Price Index (CPI) is an indicator of changes in consumer prices experienced by Canadians. It is obtained by comparing through time, the cost of a fixed basket of commodities purchased by consumers. Since the basket contains commodities of unchanging or equivalent quantity and quality, the index reflects only pure price change.
...The CPI is widely used as an indicator of the change in the general level of consumer prices or the rate of inflation. Since the purchasing power of money is affected by changes in prices, the CPI is useful to virtually all Canadians. Consumers can compare movements in the CPI to changes in their personal income to monitor and evaluate changes in their financial situation.
CPI is calculated on the national level, as well as provincially. It's the provincial data we'll be examining today. The data source is Stats Canada (CANSIM table 326-0020) and CREA. Both indexes have been set to 100 in Q1 1980 and have been adjusted quarterly.
Of note, the Teranet Index is the superior index in examining house prices and inflation as it strips away the influences of changing consumer preferences (i.e. larger houses). The Teranet index uses a paired-sales methodology whereby house price increases are determined by examining the changes in the sale price of the same house over time. CREA data does not account for this. However, since Teranet data only goes back to the early 90s and is based on Canadian cities rather than provinces, the CREA data will have to suffice, as imperfect as it is.
Discussion:
As with many other fundamentals that we've examined, most provinces except BC and Ontario track inflation closely until the early or mid 2000s at which point they abruptly depart from the trend. To believe that the divergence between house prices and rents/incomes/inflation/GDP will not at least narrow is to embrace the dangerous mantra that 'this time it's different', a mantra that has cost many dearly.
While some may argue that the inflation statistics have been massaged lower over time, there is a multi billion dollar Canadian bond market that strongly disagrees. For reference, the bond market is over ten times the size of the stock market, dwarfing it in capitalization.
So the question remains: Is it really different this time, and if so, why?
Cheers,
Ben
Posted in:
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7 Comments
The rise in house prices is easily attributed with the acceleration of mortgage credit in the last decade.
And the acceleration of mortgage credit was fueled with low interest rates after the dot com crash, CMHC lowering lending standards and real estate fever that hit most parts of Canada.
It was not incomes or savings that raised house prices in this Country, but debt.
On another note, it looks like Australia's housing market is finding out how long the attitude of " it is different here" can last.
Kevin, Australia's market is showing signs of weakness but it hasn't fallen yet. There are a lot of rabbits the government can still pull out of its hat.
The latest from Bank of Canada Governor Mark Carney
http://www.bankofcanada.ca/2011/05/speeches/canada-in-a-multi-polar-world/
"While emerging economies are having difficulties absorbing large private flows, advanced economies have often misallocated surges in yield-insensitive gross claims. In Canada, as elsewhere, large capital inflows will require vigilance from public authorities and private financial institutions. Financial history, particularly during times of large power shifts, is rife with examples of booms stoked by dumb money that turn good situations to bad."
"The possibility of greater momentum in household borrowing and spending in Canada represents an upside risk to inflation in Canada. The persistent strength of the Canadian dollar could create even greater headwinds for our economy, putting additional downward pressure on inflation in Canada."
Yeah, he said "dumb". I prefer the more politically correct term "stupid".
Only one question about the speech of mr. Mark Carney the governor of Bank of Canada.
How can I believe the Bank of Canada or Mr. Mark Carney when they say the inflation is 2 % ! ?!?!?
The reallly thruth is that the inflation is much more high and is created from the debts thanks to the printing money from any central banks in the world. The banks make money with debts and they want people under debts without debts they will disappear. To avoid this unresponsible debt we should go back to the gold standard as monetary policy but this means no free debts with printing money. Most of the high cost of leaving today is because the free printing money as in Usa where the Fed tell people the inflation is 2% as well but instead as in Canada in Europe and everywhere is instead between 5 and 10 % !!
TOP STORY ON BLOOMBERG TONIGHT - CHINA MAKES VANCOUVER PRICER THAN VANCOUVER
http://www.bloomberg.com/news/2011-05-16/chinese-spreading-wealth-make-v...
http://bloom.bg/kXRK20#ooid=RvaGZnMjoDlXr_vw3lrRIxTDPcbqvjsT
Did anyone notice that Ben scored a guest post on Hong Kong based alsosprachanalyst.com Thats a great China watch blog by the way.