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Why Might The Fed’s Party Be Over?

Posted by Larry Doyle on June 20, 2011 8:07 AM |

Over the last few years I have highlighted the fact that the deflationary impact of declining wages and home values gave cover to the Federal Reserve for maintaining an excessively easy monetary policy and pumping up asset prices via quantitative easing. That party would now seem to be over. Why?

There is no doubt that Fed chair Bernanke’s easy money has played an integral role in the inflation we are experiencing at the pump, in the supermarket, and across a number of other commodities.

As we continue to navigate the U.S. economic landscape circa 2011 and beyond, the ongoing decline in home values in many regions of our nation now would seem to be setting the table for an inflationary spike in housing costs. How so? What is going on here? 

Clearly many of our fellow citizens remain underwater in their current mortgage. Many others can not or choose not to purchase a home (for a variety of reasons) despite the seemingly compelling values. Housing in many regions is entering a Depression-like phase. In the face of these realities how is it that housing could actually be a source of inflationary pressures and thus a real concern for the Fed as we move forward?

People need to live somewhere, right? While many people may look to move back in with Mom and Pop or double up with friends, these options do not work for everybody. Thus, while home prices may be languishing, the costs of renting are trending higher. This reality presents another real challenge for the Federal Reserve.

For the purposes of measuring inflation, how does the Bureau of Labor Statistics and in turn the Federal Reserve measure housing costs? The cost of purchasing or the cost of renting? Anybody want to venture a guess? Might it be a blended assessment? Nope. The BLS and Fed utilize the cost of renting in determining the overall level of inflation. Let’s navigate and address this new and challenging hurdle along our economic landscape.

The Financial Times highlighted this new hurdle for the Fed in writing, Falling House Prices Mysteriously Fuel Inflation,

Here is a mystery: house prices in the US are going down and yet house prices are driving up the core rate of inflation.

According to the Case-Shiller index, US house prices fell at an annualised rate of 4.2 per cent in the first quarter of 2011; but according to the consumer price index, the price of “shelter” rose at an annualised rate of 1.4 per cent over the past six months, compared with 0.8 per cent for the six months ending last November.

The answer to this conundrum has implications for how inflation will move in the months ahead and, therefore, for how the Federal Reserve will set monetary policy.

It also shines a light on the occasional perversity of economic statistics because the indirect driver of inflation is the foreclosures that are devastating the US housing market.

Foreclosures have pushed more people into a limited supply of rental housing. That has prompted a recovery in rents. The NAHB’s sentiment index for market-rate rental units has hit its highest level for five years while big apartment owners are reporting rents rising at an annual pace of 2-3 per cent.

That affects the CPI because the Bureau of Labor Statistics uses rents not just for those houses that are actually rented but also to measure the implicit cost of all the houses that are actually occupied by their owners.

The effect on the inflation data is large because actual and implied rents amount to about 30 per cent of the consumer price index. According to analysts at Goldman Sachs, housing accounts for more than 60 per cent of the acceleration in the core consumer price index compared with 12 months ago. (LD’s highlight)

The reason for measuring housing this way is that a home divides into an asset, which the owner can sell again in the future, and the service of “somewhere to live”. Only the latter part is consumption.

People do not buy and sell their house every month so using house prices would tend to make the inflation data much more volatile. Using rents rather than house prices meant inflation did not rise nearly so far during the housing boom, or fall so fast during the bust.

Until 1983, the BLS used a measure based on house prices but changed over to use rents. Many other industrialised countries use something similar but Europe solves the problem by excluding owner-occupied housing from its CPI.

Another quirk of measurement is that, unlike other prices that it measures month-to-month, the BLS compares rents with those of six months ago. Added together, the result is that the core CPI, excluding volatile commodities such as food and energy, tends to show a lot of momentum.

Capital Economics forecasts the US rental market will be the best performing housing sector for the next five years, with rents rising by 2 to 4 per cent a year and that suggests core prices will keep moving upwards even if inflation does not accelerate.

For the Fed, the very low level of core inflation last autumn was the single biggest reason why it launched the second, $600bn round of asset purchases that came to be known as QE2.

Although the Fed concentrates on a different measure of inflation, which has a lower weight on housing, the pickup in rents is another reason why a “QE3” is unlikely.

What are the implications of no QE3 (quantitative easing)? No more “punch bowl” provided by the Fed and hence a strong likelihood that the bubbling up of asset valuations has run its course.

The party’s over!! Navigate accordingly.

Larry Doyle

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I have no affiliation or business interest with any entity referenced in this commentary. The opinions expressed are my own. I am a proponent of real transparency within our markets so that investor confidence and investor protection can be achieved.


  • fred


    I agree fully with with your conclusions, cpi (current calculation),which has been conveniently tracking lower for the past 25 years is now postured to increase for the forseeable future.

    Never fear though, I’m sure that the Fed will modify “core” in such a way as to justify any action it wants to take reguarding QE.

    I would like to propose, however, that a price index/indicator with such far reaching consequences (fed policy, COLA, asset valuation, etc.), is long overdue for an overhaul to better reflect the reality it is suppose to express.

    How can we expect to get social security and medicare reform “right” if the CPI does not accurately track the cost of living of the average consumer.

    As example, if over 2/3 of consumers “own” their own home it’s hard to justify rental expense as the full housing component in the cpi calculation. But an equal arguement exists for the exclusion of home prices; the reason being that the average homeowner has a fixed monthly mortgage expense which does not fluctuate at all with current prices.

    To feed the discussion even further, one might argue for a number of different calculations to more accurately reflect prices for the constituency most affected, for example a “senior cpi” might be useful for establishing social security cpi whereas the “senior cpi” is not nearly as useful when applied to wage increases. If we adopted a number of different calculations, the Fed could take some sort of mean/median when implementing policy.

    Let the debate begin, but let’s let consumers decide rather than politicians, statisticians and special interests.

    • LD


      Your point is a good one and I think we will witness more private sector entities developing and highlighting the real costs of living and real costs of doing business going forward.

      To give credit where it is due, you were the one who informed readers of this blog of the Billion Prices Project, which

      is an academic initiative that uses prices collected from hundreds of online retailers around the world on a daily basis to conduct economic research.

      This page shows our most recent research leveraging high-frequency price data, as well as the US daily inflation index (updated monthly on this page).

      Additionally, to the extent that the government continues to game the system and the data it releases, make no mistake the costs of that gaming are further erosion of confidence in our government and an increase in the “throw the bums out” mentality which lies at the foundation of the Tea Party.

  • James

    The “purchase to rent” model is beginning to look very attractive and will likely get more attractive in the future. Those with liquidity may want to look as cash on cash returns in selected markets approach and exceed 10%.

    • Mark


      Good point. In fact, this very type of purchase to rent activity is highlighted in a Bloomberg commentary, Brazilians Buy Miami Condos at Bargain Prices,

      Frederico Azevedo went to Florida looking for a second home. He left with three, paying $300,000 and $500,000 for condos in two Miami towers, and $1 million for a unit at the Trump International resort in nearby Sunny Isles.

      “I bought one to use as a vacation home and the other two as investments,” Azevedo, 39, president of Construtora Altana Ltda, a housing-development company, said in a telephone interview from his office in Sao Paulo. “It’s actually very cheap in Miami compared to here.”

      Surging real estate prices in Brazil and the currency’s 45 percent gain against the U.S. dollar since 2008 are sending Brazilians to South Florida in search of bargain vacation homes and property investments. That’s helping bolster Miami’s condo market, with total sales increasing 92 percent in the first four months of 2011 from a year earlier, according to data from the Florida Association of Realtors.

  • CuiJinFu

    Welcome to the world of tortured government statistics. This decision by the Fed to only include “Owner’s Equivalent Rent” in inflation calculations will be remembered as intellectually dishonest and one of the main enablers of the housing bubble. This was one of the first examples of a now consistent pattern of removing inconvenient items from the inflation statistics that interfere with the “right” answer…that inflation is and always will be defined as “low”.

    The focus on core CPI excluding food and energy is the latest example of this. Economists argue that these items are “volatile”, so we should just ignore them completely, as if using a moving average over a reasonable time scale to mute short term volatility is beyond their analytical capabilities. The net result is they can effectively hide the steady rise of these costs behind a cloak of “volatility”.

    Now these obfuscations have come back to bite them. The Fed for over a decade has defined away significant inflation in the housing sector, in the process ignoring the biggest financial bubble in history. Now that the deflation has arrived to correct those previous excesses, the Fed wants to fight it. But it’s intellectually dishonest for them to call the situation in the housing market deflationary when by their own definition it was not inflationary on the way up.

    But you can be sure that the rules will soon be changed to “fix” that. Now that the inflation statistics are starting to give the “wrong” answer, we can expect that the government will suddenly have a change of heart with regard to using OER for inflation calculations.

  • JCT


    When everything is excluded, then there will be no problem in reporting that we have no inflation. There will also be no problem in “storming the government fortress” that failed to both protect and regulate.

    How will they “fix” that?

  • David

    But Bernanke wants inflation so this may be playing right into his hands. Screw the American middle class but so be it. Drive some inflation into the system in hopes of monetizing the debt.

  • Steve

    Ben says no more ‘punch bowl’ and the market gives back a quick hondo.

    The Party’s Over Now……

  • Dandy Don

    The phrase utilized in your commentary was immortalized by many but none better than one of the original Monday Night Football hosts, Dandy Don Meredith,

    Turn Out The Light’s The Party’s Over

  • fred

    Some would argue the TARP program should have been directed towards mortgagees rather than mortgagors; afterall don’t the banks already have a “guardian angel” in the Fed?

    Some say the recent spike in gold is a harbinger of a massive and combined fiscal and monetary relief package working its way through the back offices of Washington and Wall Street.

    If so, what form would this “relief package” take. Maybe a combined Fed purchase of “performing” MBS and a forced resumption of refinancing activity by banks for all current mortgages (reguardless of equity position) and a renewed emphasis on mortgage restructuring and refinancing through gov’t sponsored programs for homeowners capable of carrying a mortgage at current rates.

    Of course to be fair, any such fiscal package would have to incluse the rest of us who either rent or remained current throughout the crisis. How about a one time tax deduction for mortgage or rent paid since 2008?

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