The Federal Reserve can’t see the probable economic crash that is coming because it’s still looking into the rearview mirror, where it sees nothing but high inflation.
The danger arises because the consumer price index and the personal consumption expenditure price index — the two most important inflation gauges — have a fatal flaw in the way they measure shelter costs.
“ If you get shelter prices wrong, your view of inflation is also going to be wrong. ”
As a result of that flaw, the price indexes will miss a crucial turning point in the effort to restore price stability. The Fed is winning a major battle in the fight against inflation, but policy makers don’t believe it. That means the Fed is likely to raise interest rates too high and keep them high for too long while it waits for confirmation, which will come too late.
Powell doesn’t get it
Fed Chair Jerome Powell was asked about this at his last press conference a week ago following another jumbo rate hike and promises to raise rates a lot more in coming months.
“I think that shelter inflation is going to remain high for some time,” Powell said. “We’re looking for it to come down, but it’s not exactly clear when that will happen.…You’ve just got to assume that it’s going to remain pretty high for a while.”
Powell didn’t even hint that the Fed was making significant progress in controlling shelter costs. Maybe Powell was just trying to stay on the hawkish message he’s been trying to deliver, but, then again, maybe Powell and other policy makers really don’t get it.
Make no mistake, shelter prices are coming down fast, even if that fact won’t be immediately visible in the official inflation statistics because of the way the price indexes are constructed. Shelter is a huge portion of the typical family’s budget and accounts for a third of the CPI (and 15% of the PCE price index). If you get shelter prices wrong, your view of inflation is also going to be wrong.
House prices fell at a 6.9% annual rate in July after a historic increase in home prices of more than 20% a year, according to the repeat-sales index reported by the Federal Housing Finance Agency on Tuesday. The Case-Shiller Index, which is a three-month average, fell at a 2.9% annual rate.
The Fed ought to be cheering this news, because it engineered it by aggressively raising overnight interest rates FF00, +0.02%, which pushed up mortgage rates. The Fed is also reducing its holdings of mortgage-backed securities through quantitative tightening, which will tend to push up mortgage rates.
The Fed has apparently succeeded in quashing a major inflationary factor: surging home prices. In the longer run, of course, the only way to control shelter inflation is to make more affordable housing, bringing supply in line with demand.
We’re all renters now
However, it’s not the price of houses that determine the measurement of shelter costs in the price indexes, nor do actual out-of-pocket expenses for mortgages, taxes, insurance and maintenance play any role in the government’s assessment of the cost of living.
Instead, the government uses the price of rental units and assumes that homeowners pay similar costs, even though about two-thirds of adults don’t rent, but live in their own home. A third have paid off the mortgage.
The assumption that homeowners are just like renters is wrong. For renters, shelter costs account for about 34% of their out-of-pocket spending each year, according to the Bureau of Labor Statistics’ consumer expenditure survey. For homeowners with a mortgage, it’s 27%. For homeowners without a mortgage, it’s 21%. And remember, homeowners also accumulate equity.
Any assumption that the cost of living of the 84 million families that own their home should be measured by what the 47 million who rent pay is not just ridiculous, it’s fatally flawed. In times of low inflation, it might be acceptable, but in times of high inflation, this assumption is sending out a misleading message.
The price of renting a house of apartment doesn’t track the price of buying perfectly, and tends to lag behind by 12 to 18 months. This means that the drop in home prices in July (and beyond, presumably) won’t really be apparent in the price of renting until next summer. And it won’t fully show up in the inflation data until then either.
Higher for longer
The Fed’s policy is to keep raising rates until the inflation data tell them to stop. But that policy is inherently backward-looking. It means the Fed is likely to brush aside any signs of progress in tamping down inflation expectations, or in tapering effective demand by destroying wealth and slowing the growth of incomes.
It means that an unnecessarily hard landing is likely, with more pain to the American economy and its people that is necessary. Not to mention what it’s doing to the rest of the world.
Rex Nutting is a columnist for MarketWatch who’s been writing about the economy for more than 25 years.