Inflation is transitory… or it may not be. It depends on whether the data is considered reliable enough that day. Bank of Canada (BoC) released a home price exuberance model, showing the market bubbles. Even more interesting is a footnote for the model they used. They feel inflation data on rent is unreliable, because it shows chronic overvaluation. So they dismissed it, despite it being used as a key data point supporting low interest rates. The data is bad when it shows overvaluation, but good when it supports higher home price growth. Oh boy. Let’s dive in.
Bank of Canada Finds CPI Rental Data Shows “Persistent” Overvaluation
The BoC made an attempt to gauge home price exuberance (bubbles), and staff shared the model. Instead of relying on traditional fundamentals, they looked at home price growth acceleration. It’s a commonly accepted method, similar to the one used by the US Federal Reserve. Only minor issues, but all models have some. That’s not the point.
The interesting part is why they opted for this method. Staff intentionally ignored some common fundamental analysis models, because of data reliability. Buried in the footnotes of their research paper was this gem:
“Alternative approaches to estimating fundamentals — such as those based in the price-to-rent ratio — generate persistent and implausibly large deviations from fundamentals because of the poor measurement of market rents in the consumer price index.”
That short statement is so jam-packed, it really needs to be dissected to be fully appreciated.
Shelter and Rent Are Very Large Influences On Interest Rates
The central bank has one primary goal — climate change. The best way to fight rising CO2 levels is with a 2.0% mortgage, and $3 billion dollars per week in quantitative ease. Just kidding, despite the central bank saying climate change is now one of their primary goals. The official mandate is actually managing inflation, by keeping it “low and stable,” as they like to say.
The inflation readings are based on the Consumer Price Index (CPI), which has a target rate (currently set at 2%). If CPI is persistently above the target, they move to increase interest rates. If CPI is below target, they move to lower rates, in hopes of stimulating borrowing.
The shelter sub-index is the largest index within the CPI. It represents 26.8% of the basket of goods used to measure the cost of living. The largest sub-component in shelter is rent, representing 6.2 of those points. More simply put, shelter is the largest influence on inflation. Rent is the largest influence on shelter. We have a big problem if the rent data in CPI is useless.
CPI Shelter Is Much Lower Than Other Measures
It’s difficult to gauge how off shelter and rental data is without looking at the raw data, but you can get an idea. CPI-Shelter increased 3.2% on an annual basis as of April, a substantial jump. Breaking down those numbers, StatCan only has rent increasing by 0.9% over the past year. Not much of an increase.
Most renters can tell you that is totally off, but more official sources also show that. Canada’s national housing agency estimates primary rental prices are up 3.7% in 2020. The only time CPI rent reached that annual growth level in the past 20 years was one month — October 2019. Other than that, you have to go all the way back to 1991 to see that level of recorded growth.
It’s easy to see why the Bank of Canada would say it was a “poor” measure. That’s got some interesting consequences though.
Interest Rates Are Based On CPI, Which Influence Home Prices
The primary tool the BoC has to keep inflation in line is the overnight rate. When inflation operates above the 2% target persistently, they increase interest rates. This reduces the amount of borrowing, by lowering maximum leverage through higher costs.
If inflation is persistently below the 2% mark, they lower interest rates. This lowers the cost of borrowing, helping people to borrow more. Higher credit capacity allows home buyers to more readily absorb higher home prices. This helps to push home prices higher.
It doesn’t matter how much demand there is, if people can’t afford something — they can’t pay the price. Since affordability is determined by how much one can borrow these days, the maximum available credit is important. More credit influences higher prices, and less influences lower prices.
CPI Rents Are Right When Keeping Rates Low, But Wrong When Showing Overvaluation?
CPI rent component is an accepted truth when determining when to move interest rates. This is despite the fact it is a “poor” measurement of rental prices. Inflation readings are consequently lower than reality. In this case, the underreported CPI supports lower interest rates, and higher home prices. No need to adjust or fix the issue.
What happens when the same fundamental data shows home prices are overvalued persistently? The CPI rent component isn’t reliable, and chronically produces overvaluation. They dismissed fundamental data that didn’t support higher prices.
The central bank supports use of the rental data when it supports higher prices. They consider it unreliable when it produces a data point that supports lower prices. Not a total surprise. Even high profile economists have begun to accuse the BoC of not showing their work. It is nice to know that even other departments at the central bank consider the data to be junk though.
Oh, yeah. Even with the bias towards higher home price growth, the model showed Toronto is a bubble.
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