What is deflation: Falling consumer prices

John Calverley - Fri 10 Dec, 2004

...One of the causes of the current housing bubbles in the UK, Australia, parts of the US and elsewhere, is that people have forgotten that house prices can fall as well as rise...

One of the causes of the current housing bubbles in the UK, Australia, parts of the US and elsewhere, is that people have forgotten that house prices can fall as well as rise.

But the risks of a significant fall are more acute now than for over 50 years - because of today’s low rate of inflation in consumer prices, and the threat of deflation.

Between the 1950s and the mid 1990s, falling consumer prices - deflation - was virtually unknown anywhere. The world’s attention was focused entirely on battling inflation - rising prices - which had become the number one economic problem. But by the late 1990s, the battle against inflation was won and deflation had emerged in several countries in Asia including Japan.

What is deflation: Falling consumer prices: New and troubling threat

Deflation is a new and troubling threat for all of us brought up in an era of continuous rising prices. Almost nobody alive today, even the venerable Mr Greenspan, was an active market participant or policy-maker in the 1930s, the last time the US and UK suffered deflation. Yet during the 19th century and right up to the 1930s, deflation was common, indeed even normal, while inflation was usually only seen at the height of economic booms and in war-time.

In the US and UK, deflation is still only a hypothetical possibility, but in Japan it is a painful reality. Japan’s stock and property bubbles deflated rapidly in the early 1990s, and a series of short-lived upswings were each soon ended by a new downturn. In this weak environment inflation gradually dropped to zero and then deflation set in, starting in 1995. As of the end of 2004, Japan’s price level has fallen a cumulative 10%.

The Bank of Japan reacted slowly when deflation first emerged. It cut interest rates to zero, but did little more to begin with. However, since 2001 Japan has performed a U-turn and has consciously printed money to try to escape deflation. Very slowly, this policy is bringing results, with the rate of deflation now reduced to near zero. But positive inflation is not likely to be firmly established in Japan until late 2005 at the earliest.

Meanwhile, in the aftermath of the collapse of the 1990s stock bubble the US went through a deflation scare in 2003, when recorded inflation sagged close to zero. Inflation is now picking up gradually, as the economy recovers and the dollar sinks, but it remains low. Inflation is also very low in the UK, despite a record 12-year economic upswing.  

What is deflation: Falling consumer prices: House price bubbles

A world of very low inflation - and potentially deflation - makes the current house price bubbles more dangerous than in the past. From an investor and home-owner point of view, it means that houses are a more risky investment.

After past price bubbles, house price adjustments were limited in nominal terms by the cushion of high underlying inflation. Indeed in the US, the nationwide price index has never fallen in nominal terms. Nevertheless, there was a 10% real adjustment in the 1990s - hidden by consumer price inflation. In some US regions prices did fall, as the real price adjustment was greater. For example in California, home prices fell 10% in nominal terms translating into a 24% decline in real terms.

At present US home prices are still in the early-to-middle stages of an emerging bubble, though some cities - particularly on the coasts - already have a significant overvaluation. With unemployment falling and interest rates rising only gradually, the bubble will probably become larger and more widespread for a while. This will provide support to the US economic upswing for the next few years, but will leave the economy exposed once the next recession comes along.

In the UK, where the bubble is much further advanced, there is a risk of a more severe correction in nominal house prices than in the early 1990s. This is partly because house prices are more overvalued today than they were in 1989, measured by the house-price earnings ratio, but also because of the effects of lower inflation. Low inflation also means that it could take a very long time for prices to recover.

The average UK house price fell 20% from 1989-93 (28% in Greater London), but the decline in real terms was even larger, some 37% (45% in Greater London). Inflation then was still in the 4-5% pa range, compared with 1-2% today. In the middle 1990s, house prices gradually recovered, reaching 1989 levels once again by 1998. It is surprising that most people seem to have forgotten how far prices fell and how long it took to come back to the peak levels.

What is deflation: Falling consumer prices: What if?

Let us suppose the current bubble bursts and there is an adjustment in real prices of 37% once again, over the 4 years to 2008. This would almost certainly be associated with a weak economy so average earnings growth would naturally slow from the current 3-4% pa rate, perhaps to 1-2% p.a. Hence nearly all of the burden would show up in nominal prices this time, instead of being cushioned by consumer price inflation. This implies a nearly 30% fall in nominal prices. Then, assume the economy and house prices recover and house prices rise in line with average earnings.

Starting in 2009, with house prices rising at the new, lower rate of earnings growth - just 2% pa - they would take a further 18 years to return to today’s level. To spell it out, a house worth £300,000 today would dip to £210,000 in four years time but not return to £300,000 until 2027.

Take note - this is not a forecast, because for one thing, the Bank of England would do its utmost to push the inflation rate up, just as the Bank of Japan has been trying to do recently. But also note that it is by no means the worst-case scenario, either. If actual deflation set in, earnings growth might slow below 1-2% pa.

If UK house prices are the same or slightly lower in 20-25 years time, this might not worry some owner-occupiers. Most people will have bought before the peak of the bubble - so while they will see some erosion of their equity, and perhaps suffer some disappointment, they may not be losing much, except on paper. Moreover, since interest rates would fall, the cost of servicing a mortgage would decline.
 
However, the element of disappointment could be important if they were in some way relying on future appreciation to help fund their retirement, as seems to be increasingly the case. Moreover, more people than in the 1990s would find the value of their house falling below the outstanding on their mortgage - i.e. negative equity - because of the greater decline in nominal house prices.

For an investor in housing, the 30% decline scenario above would, to say the least, be a huge disappointment, because there is no capital gain for more than 20 years. Of course, provided he could find tenants and provided rents did not fall, his net rental yield should be positive. So there would be some income after costs, though not much given the low level of rental yields. It is difficult to define exactly where the investor would end up, because a great deal depends on how big a loan he has and what rent he could obtain. But there is no doubt that this is what disappointed investors call “a very long term investment” - or in other words, a mistake!

The choice is either sell and accept the loss, or wait it out - but then miss the opportunity to make money elsewhere.

In recent months all the main UK house price indices have peaked out after the huge gains witnessed over the last 7 years. Prices in some areas have already started to fall, and my guess is that the general indices will show a decline over the next year, but probably only by 5% or so.

The big adjustment, inevitable at some point, will happen when we see a sharp slowdown or recession. The UK has avoided a recession for 12 years now, the longest continuous upswing on record, and should be able to continue to grow for a while longer. But a recession will come one day.

Meanwhile, in a low inflation world, the housing bubble is an accident waiting to happen.


Regards,

John Calverley
for The Daily Reckoning

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