Deflation Meets Inflation: Real Estate In 2007 & Beyond (Part I)
Daniel R. Amerman, CFA
Overview
It has been widely reported that the United States housing market fell by 8.9% in 2007. As we will explore in this article – when we include inflation, the real decline in single-family home values was 50% higher than reported. For 2007 was not just the worst year for housing in the 20 year history of the S&P/Schiller index, but the worst year for inflation in 17 years. The forces of asset deflation were not battling the forces of monetary inflation – they were working as a team to pull down the real net worth of tens of millions of homeowners.
As we will see, there is no time that monetary inflation is more deceptive – or dangerous – than when it is working with asset deflation, its oftentimes partner in crime. What happens when monetary inflation meets asset deflation is not understood by most of the population. Hidden within the convergence of those two fundamental forces will be the likely “solution” to the current housing crisis, as well as opportunities for astute individuals to protect and even increase their net worth during a time of falling real home prices.
(This article is part of the Why Inflation Will Trump Deflation series, and Part II will contain Reason Five. This two part article can be read on its own, and does not require reading the previous articles in advance.)
Inflation Lies & Inflation Truth
As prominently reported in the national media, there was an 8.9% fall in the average value of single family homes in the United States in 2007 (according to the S & P / Case-Schiller U.S. National Home Index). This was the largest annual loss in the 20-year history of the index. This number was literally true – but economically it was less than fully accurate, for it left out something very important indeed. For 2007 was not only the worst year for the real estate market in years – but the worst year for the dollar. Between January 1st and December 31st of 2007, the US Consumer Price Index (CPI) rose by 4.1%, the largest calendar year increase in 17 years. When we look at wholesale inflation, which tends to lead consumer inflation, the 12 month Producer Price Index (PPI) jumped 7.4% between January of 2007 and January 31 of 2008 – the highest 12 month rate of inflation seen in 26 years.
(For the rest of this article we’re going to treat current inflation as being 5.9%, which is the blended average of the January 12 month CPI & PPI rates of 4.3% and 7.4% respectively. This is offset by one month from the housing index, but better reflects the year-end trends we’ll discuss in a bit.)
The most important thing to remember about inflation is that it is both a liar and a thief. A thief because it quietly takes from your net worth through reducing the value each year of what your dollars will buy. What makes inflation a particularly clever thief is that it is a liar that hides genuine losses, even as it presents false profits. For example, let’s say you have an asset worth $100,000, and there is a 5% inflation rate. The asset keeps up with inflation, and is therefore worth $105,000 at the end of the year. Now, that sure looks like a $5,000 profit – and it is taxed as a $5,000 profit. But it isn’t, because inflation took $5,000 of your purchasing power, and all you did was break even. Your $105,000 at the end of the year will buy you no more reality (goods and services) than your $100,000 would have at the beginning of the year, and your “profit” was a (fully taxable) lie.
Real Estate In 2007
Which raises the question: what happens if your asset doesn’t keep up with inflation? That brings us back to the single-family home market in 2007, and the chart below:
To explore what the graph means, we’ll use an example home. Let’s assume you started off with a home that was worth $300,000 at the beginning of 2007. If its value changed exactly like the national average for single family homes over the year, by the end of the year it would have lost 8.9% of its value, and be worth $273,000, for a loss of $27,000. Ouch! Except, that is only part of the damage, because those dollars at the end of 2007 wouldn’t buy as much as they did at the beginning of the year. Economists use the terms “nominal” and “real” to distinguish between the dollars themselves, and the separate issue of what those dollars will buy. Our $273,000 is simply the number of dollars, the nominal – and what it omits is that the purchasing power of each of those dollars has fallen over the year.
To find the real, we need to adjust for the 5.9% rate of inflation. When we do that, we find that $273,000 at the end of the year would only buy what $258,000 would have bought at the beginning of the year. So the decline in the simple (nominal) value of our house cost us $27,000, and the decline in the value of what a dollar will buy cost us another $15,000, and at the end of the year – in real terms – we lost a total of $42,000. Our real loss was 14%, which was a full fifty percent higher loss than the 8.9% that was publicly reported. In other words, the average homeowner in America took a loss that was 50% greater than what was reported in the papers and on TV.
A Double Quickening
What makes the situation even more disturbing is when we look at more recent numbers. The 8.9% decline in housing prices was not evenly spread over the year – rather, 5.4% of it occurred in the last 3 months of the year, and only 3.5% occurred during the first nine months. If we consider simple averages, the monthly decline in nominal housing prices accelerated from 0.4% in the first three quarters of the year to 1.80% monthly in the last quarter, a deflationary acceleration of 350%. Using simple annualization (multiplying times 12 rather than using an exponential function), that means the nominal rate of housing deflation increased from 4.8% in the first 9 months of 2007, to 21.60% in the last 3 months of 2007.
The last few months of 2007 and the first month of 2008 also made big news in another area as well. In January of 2008 the PPI – the measure of wholesale inflation – jumped to a monthly rate of 1%, which equals a full 12% annual rate of inflation. More than any other single number, this one month acceleration is what accounted for the 12 month PPI reaching its highest annual rate of increase in 26 years.
In other words, we have a double acceleration in progress. It’s not just that houses are deflating at the highest rate in the 20 year history of the index – or that 12 month inflation as measured by the PPI just hit its highest level in 26 years – but that both of these annual records are the result of a quickening that occurred in the last few months of 2007 and the first month of 2008 (for the PPI and CPI). What happens if these accelerated short term rates continue for the rest of 2008?
As an illustration, the graph above extrapolates the October to December 2007 rate of housing deflation, and combines it with the January 2008 rate of monetary inflation. When the deflation rate is annualized, the average house loses 21.6% in dollar terms. When the inflation rate is annualized, the dollar loses 12% in purchasing power terms. And when deflation meets inflation – the average home would experience a 30% combined fall in real value in 2008, if these rates were to persist.
What does that mean in dollar terms? Let’s go back to our example where we start the year with a $300,000 house. If you experience a 21.6% deflation in simple (nominal) terms, that would drop the dollar value of your home to $235,000. When we adjust for what a 12% rate of inflation will do to what a dollar will buy, the value of your home has now fallen to $210,000. In other words, if we extrapolate forward the most recent inflation and housing figures, your real loss could be $90,000, or a full 30% of the value of your home in one year.
Looking Ahead To The False Floor
The above is intended to be an illustration rather than a projection or a prediction. Monthly and quarterly rates do bounce around quite a bit, and hopefully things won’t work out quite as badly as a straight extrapolation of recent asset deflation and monetary inflation rates would indicate. However, I think that we can make a prediction that something else will happen. At some point, whether it is this year or three years from now, we will reach what will be called a floor. It will be widely reported that the damage has been stopped!
Be very careful about what you believe – because what you will likely be seeing is a false floor that is based upon the lie of inflation. This is illustrated in the graph below:
For if asset prices stabilize, but monetary inflation has not – then a floor is not a floor at all, but rather a continuing plunge that has been hidden by that old liar we know as inflation. If housing prices stabilize, and do not rise or fall, but the rate of inflation is equal to 10% -- then you have just lost a further 9% of the value of your home. (See (*) at the end of the article for why a 10% rate of inflation drops the value of a house by 9%).
(To be continued in Part II of this article)
Do you know how to Turn Inflation Into Wealth? To position yourself so that inflation will redistribute real wealth to you, and the higher the rate of inflation – the more your after-inflation net worth grows? Do you know how to achieve these gains on a long-term and tax-advantaged basis? Do you know how to potentially triple your after-tax and after-inflation returns through Reversing The Inflation Tax? So that instead of paying real taxes on illusionary income, you are paying illusionary taxes on real increases in net worth? These are among the many topics covered in the free “Turning Inflation Into Wealth” Mini-Course. Starting simple, this course delivers a series of 10-15 minute readings, with each reading building on the knowledge and information contained in previous readings. More information on the course is available at InflationIntoWealth.com .
Daniel R. Amerman, CFA
Website: http://InflationIntoWealth.com/
E-mail: mail@the-great-retirement-experiment.com
(*) The loss is 9% rather than a simple 10% because we have to convert from the inflation rate to a dollar deflator, in order to calculate declines in purchasing power. This need to convert inflation into a deflator actually gets to the heart of one of the most deceptive aspects of inflation – we measure inflation as an increase, and discuss it as an increase, but the real nature of inflation is actually to deflate the value of each dollar, hence the need for the conversion to a dollar deflator. This is not only confusing mathematically – but can be intuitively confusing for many people as well.
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