The Federal Reserve can’t see the likely economic downturn coming because it’s still looking in 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 indicators of inflation, have a fatal flaw in the way they measure housing costs.
“ If you get house prices wrong, your view of inflation will be wrong too. “
As a result of this flaw, price indices 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 policymakers don’t believe it. That means the Fed is likely to raise interest rates too high and keep them high for too long while waiting for confirmation, which will come too late.
Joy Wiltermuth: Zillow sees rent growth, but that’s not what the Fed is tracking
Powell doesn’t get it
Fed Chairman Jerome Powell was asked about this in his latest press conference a week ago after another jumbo rate hike and promises to raise rates much more in the coming months.
“I think shelter inflation is going to stay high for a while,” Powell said. “We’re looking for it to come down, but it’s not exactly clear when it’s going to happen. … You just have to assume it’s going to stay pretty high for a while.”
Powell did not even hint that the Fed was making significant progress in controlling housing costs. Maybe Powell was just trying to stick to the hawkish message he’s been trying to deliver, but then again, maybe Powell and other policymakers really don’t get it.
Make no mistake, house prices are falling rapidly, although this fact will not be immediately visible in official inflation statistics because of the way price indexes are constructed. Housing is a large part of the typical family’s budget and accounts for a third of the CPI (and 15% of the PCE price index). If you get house prices wrong, your view of inflation will be wrong too.
Nutting Rex: Real home prices fall after double-digit gains, but relief won’t show soon in inflation reports
Home prices fell at an annual rate of 6.9% in July after a historic increase in home prices of more than 20% annually, according to the repeat sales index reported on Tuesday by the Federal Housing Finance Agency. The Case-Shiller index, which is a three-month average, fell at an annual rate of 2.9%.
The Fed should applaud this news, because it engineered it by aggressively raising interest rates overnight FF00,
which drove up mortgage rates. The Fed is also reducing its holdings of mortgage-backed securities through quantitative tightening, which will tend to raise mortgage rates.
The Fed has apparently succeeded in suppressing a major inflationary factor: rising house prices. In the long term, of course, the only way to control housing inflation is to make housing more affordable, aligning supply with demand.
We are all renters now
However, it is not the price of houses that determines the measure of housing costs in price indices, nor do actual out-of-pocket expenses for mortgages, taxes, insurance and maintenance play any role in assessing the cost of living government.
Instead, the government uses the price of rental units and assumes that homeowners pay similar costs, even though about two-thirds of adults do not rent but live in their own homes. A third have paid off the mortgage.
The assumption that landlords are like tenants is wrong. For renters, housing costs make up about 34 percent of their out-of-pocket expenses 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 that owners also accumulate capital.
Any assumption that the cost of living for the 84 million families who own their homes should be measured by what the 47 million who pay rent 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 a misleading message.
The rental price of an apartment house does not track the purchase price perfectly and tends to lag by 12 to 18 months. This means that the fall in house prices in July (and presumably beyond) won’t really be reflected in the price of rent 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 inflation data tells them to stop. But this policy is inherently backward. It means the Fed is likely to dismiss any sign of progress in lowering inflation expectations or reducing effective demand by destroying wealth and slowing income growth.
It means an unnecessarily hard landing is likely, with more pain for the American economy and its people than is necessary. Not to mention what it’s doing to the rest of the world.
Rex Nutting is a MarketWatch columnist who has been writing about the economy for more than 25 years.
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