Economists' Commentary: Inflation Hits Homes

November 21, 2008

By Arun Barman, Research Economist

Through much of the 1990s inflation faded from financial headlines. Global trade, cheaper goods and services from emerging countries like China and India, improving technologies, and worker productivity helped pave the way for lower prices. In the past couple of years, however, inflation has made its way back into financial headlines. Led by sharp increases in energy prices (often seen directly by consumers in the form of higher gas prices and utility bills), inflation has been creeping up in recent years (though it has calmed during the recent financial crisis).

Economists often cite two Bureau of Labor Statistics surveys as key measures of inflation: the Consumer Price Index (CPI) and the Producer Price Index (PPI). The PPI measures the monthly change in prices received by domestic producers. Since it measures price changes from the producer standpoint, it is often thought of as a leading indicator of inflationary pressures that will show up in the Consumer Price Index (CPI), which measures the change in prices that consumers pay for goods and services.

REALTORS® are probably familiar with the PPI and CPI as indicators that the Federal Reserve uses to help make decisions regarding interest rates. When these indicators show that the inflation rate is rising too strongly, the Federal Reserve may raise interest rates in order to stem inflation. Likewise, when the economy is not facing inflationary pressures, it provides the Federal Reserve flexibility to lower rates.

Aside from the headline index numbers that are seen monthly in financial headlines, these indices contain more detailed information about price changes across sectors of the economy. Some of these can be of particular use to those in the housing industry. The PPI contains several construction related indices that cover residential and non-residential construction costs. These data can be very useful in spotting trends in prices of materials and components used in specific types of construction. The table below shows the year over year change in index values for three of the construction related indices: inputs to construction industries, inputs to construction of non-residential buildings, and inputs to construction for residential buildings. Construction costs were increasing very little from 1998 to 2002. In 2003 there was a modest uptick, and in 2004 costs increased by over 7 percent. From 2005 through 2007 there was a continuation of these significant increases in construction prices. A big factor in the rising cost of construction was related to a surge in commodity prices globally: steel, iron, crude oil, and other commodities saw large price increases that impacted construction costs.

As a comparison, the table also shows the PPI for finished goods, "core" PPI which excludes the highly volatile food and energy, PPI energy index, Census's median new home prices, and NAR's existing single family home prices. The "core" PPI increased mildly over this period never increasing more than 2.5 percent. The PPI for finished goods saw slightly larger increases in 2005 and 2007. Energy costs measured by the PPI show wild fluctuations comparatively, ranging from -17.1 percent in 2001 to 23.5 percent in 2005. NAR's existing single family home prices saw sharp increases from 2001 to 2005, before a steep decline in 2007. The Census Bureau's new home sales had a considerable price increase in 2002, but the largest increase of 13.3 percent occurred in 2004 and 9 percent in 2005 coincided with the rise in construction costs that began rapidly increasing in 2004.

Another measure showing the rising costs of housing comes from the National Association of Home Builders (NAHB). NAHB provides an estimated cost per square foot for building a home. The table below shows the cost per square foot from 1999 to 2007 which increased 33.1 percent over this period. This is very close to the PPI residential construction index which rose 33.6 percent over the same period. An interesting note is that size of homes also increased 9.9 percent over that period from 2,033 square feet to 2,235 square feet. So not only did the construction costs for building homes increase, but also the size of houses increased adding to higher prices of new homes.

While a rise in commodity prices and construction costs was not the predominant factor in the rapid rise of existing home prices, it does play a part in elevating prices of new homes and commercial buildings. Also, looking at price increases across various sectors helps to put housing related inflation in perspective. The graph below shows NAR existing home prices, PPI residential construction, PPI core, and PPI energy all indexed to 100 in September 1999. The energy index by far saw the greatest increase over this period. Not surprisingly, the PPI core (which is the PPI not including food and energy, was the most modest over this period. Home prices moved similar to energy until 2006 when they started to fall back. Interestingly, residential construction costs rose modestly until 2003, then began to accelerate. Recent years have seen big changes in home prices, but it is important to understand that building costs, energy, food, and other commodities have also experienced large price changes this decade.

This is one in a series of commentaries by the Research staff of the National Association of REALTORS®. Read more commentaries >

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