How Inflation Lowers Inflation
As new money is created by the banking system, it enters the price system as the recipients spend it. As the prices of some goods rise, this should be captured in the CPI, right?
Not necesssarily. New money does not impact all prices uniformly. And the CPI does not include all prices, only consumer goods prices, and even then unevenly. If the effect of the new money is mainly felt through financial assets or those consumption goods not included in the CPI, then the CPI will not reflect impact of the new money on prices.
Substitution can even reduce the CPI. As money is created through the banking system by expanding credit, credit-sensitive assets may at the same time increase in price and become more affordable due to lower interest rates, so people may substitute credit-sensitive purchases for cash-purchases. If certain goods are primarily paid for in cash, their prices may even fall. If the falling prices are included in the CPI, then the CPI may decline during an inflationary period. And that is what's happening with housing. Housing is a large component of the CPI. The housing component of the CPI consists not of home prices, but of "owner-equivalent rent", a measure of how much it would cost home-owners to rent their home from themself. This rental input to the computation is estimated from prices in the rental market. So, while home prices doubled between 2000 and 2006, rents lagged because home ownership increased relative to renting as the primary means of shelter. This had the effect of keeping the CPI relatively low because the rapid increases in the cost of home buying were not counted.
Barry Ritholtz has been following ongoing developments in the relationship between the CPI and the rent/buy differential on his blog (see: OER, CPI and the Fed: A Strange Love Story and OER / CPI and New York Rentals).
The key points as Ritholtz explains are:
- Core CPI is dominated by Owner's Equivalent Rent (OER).
- Existing Home Sales in the NorthEast are outpacing the rest of the country.
- Existing Home Sales in New York are far outpacing the NorthEast.
- Manhattan Condos/Coops are far outpacing NY.
In summary, the owner-equivalent rent is slowing because of the strength of the New York apartment market. This shows up as a lower CPI. The Austrian Theory of the Business Cycle provides an explanation for how, in the early stages of an inflationary boom, financial asset prices will tend to rise while consumption good prices will remain stable. Because of New York's position as the leading financial center, financial asset price inflation tends to show up as an increase in the incomes of people working in the financial sector. That is what is driving the New York real estate market.
More inflation, lower CPI.