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What Treasury Bubble?


Home prices reveal that real interest rates remain high.

CPI and CS-CPI vs. Fed Funds Rate

On September 3, 2008, I made the claim that Real Interest Rates Are High.

The claim was based on a belief that the "Owners' Equivalent Rent" (OER), the largest component in the CPI, is wildly overstated. I have new charts to support this theory - but first let me restate the background.

OER is a process by which the Bureau of Economic Analysis (BEA) estimates what it would cost if owners were to rent the homes they own from themselves. I don't believe this to be a valid construct of prices.

By ignoring housing prices, the CPI massively understated inflation for years. The CPI is massively overstating inflation now.

In normal times, when rents were in synch with home prices, it didn't matter much if one used OER or actual home prices. It's a remarkably different story now. We've just seen the biggest housing bubble in the history of the world. At the peak of the insanity, home prices were 3 standard deviations above rental prices and 3 standard deviations above wage growth.

Now, the important factor is that home prices are crashing, with quite a big drop still needed to get back to historic norms. With that in mind, housing can be expected to be weak for quite some times.

The Treasury market seems to have figured all this out quite nicely. Pundits screaming "Treasury bubble" clearly have not.

The following charts are from my friend "TC," who graphed data from the BEA and Case-Shiller. Please see the Case-Shiller Analysis October 2008 release for a look at the latest data.

OER vs. Case Shiller

Click to enlarge

Note how much OER lagged Case-Shiller in summer of 2005 right at the peak of the housing bubble, and how much OER is above Case-Shiller now.

This has a huge effect if factored into the CPI, as the following chart shows.

CPI and CS-CPI vs. Fed Funds Rate

Click to enlarge

In the summer of 2005, the above chart shows the CPI at just over 4%, with the federal funds rate just under 4%. CS-CPI, a better measure of the CPI, was close to a whopping 8%. Thus real interest rates were stunningly low starting in 2003. The Fed kept interest rates too low for 2 years. This clearly contributed to the housing bubble.

The situation reversed in the autumn of 2006, with the federal funds rate at 5.25% and CS-CPI under 1%. This helped pop the bubble (a good thing), but it would have been better not to have a bubble in the first place.
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