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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.


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