June 15, 2006

How Not to Fight "Inflation"

The ongoing debate about the significance of owner's equivalent rent within the consumer price index is yet another example of how hapless the nation's dismal scientists are as they continue to formulate monetary policy based on fundamentally flawed measures of "inflation".

As you'll recall, most economists restrict the usage of the word "inflation" to mean "core inflation", which excludes things like energy and food, and since 1983 has utilized Owner's Equivalent Rent (OER) in lieu of actual costs of home ownership.

To determine OER, instead of measuring what homeowner's costs actually are - items such as principle, interest, taxes, insurance, upkeep, etc. - the Bureau of Labor Statistics asks homeowners, "If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?"

So, "core inflation" today is made up of about 38 percent housing rental costs - 30 percent OER and another 8 percent reflecting the prices paid by people who actually rent.

If you're a central banker in an Anglo Saxon country this is a great deal because you can have home prices skyrocket and these costs don't show up in the consumer price indices. High home prices boost the economy in many ways - many new mortgage lending and construction jobs are created and consumption increases dramatically through easy home equity withdrawal - but they don't hurt the banker's bottom line of price stability.

In a strange twist of fate however, as short-term interest rates continue to be pushed up, what has in recent years suppressed "core inflation" - declining demand for rental units while nearly everyone was out buying up real estate - is now working against central bankers for a number of reasons:

  • Fewer people can afford to purchase homes at current sky-high prices and higher interest rates and will rent instead
  • Some homeowners can no longer afford the adjustable rate loans they took out a few years ago after they started to adjust upward and will go back to renting
  • Apartment building owners are coming in late to the game and converting staid apartment buildings into condos, reducing the supply of rental units

All this tilts the supply-demand equation in favor of the landlord, at least for the time being, and now rents are rising.

Housing rental costs that have behaved so well in recent years, checking in with benign price increases month after month, year after year, are now turning against their master. The single statistic on which central bankers are judged when they show up for their annual performance reviews is now out of control due to rent.

But is this fair to the central bankers? Maybe not.

Is basing monetary policy on this rent-bloated "core inflation" prudent? Well, that depends.

Taking a look at year-over-year core inflation with and without OER in the chart below, it is clear that without OER, core inflation has been essentially flat for some time now. In fact, core CPI less OER has been trending downward since it reached a peak in early 2005.

The same trend can be seen when six months of data is annualized as shown in the chart below. While OER is rising dramatically, without it, "core inflation" is essentially flat and within a range that appears normal. In fact, when including yesterday's data, the most recent measure shows a decline.

The six-month annualized figure was cited in last week's speech by Ben Bernanke. That is, the speech on June 5th to which most market participants had a violent reaction, after hearing words like "unwelcome" and "vigilant".

While monthly inflation data are volatile, core inflation measured over the past three to six months has reached a level that, if sustained, would be at or above the upper end of the range that many economists, including myself, would consider consistent with price stability and the promotion of maximum long-run growth. For example, at annual rates, core inflation as measured by the consumer price index excluding food and energy prices was 3.2 percent over the past three months and 2.8 percent over the past six months. For core inflation based on the price index for personal consumption expenditures, the corresponding three-month and six-month figures are 3.0 percent and 2.3 percent. These are unwelcome developments.

The 2.8 percent rate cited above is the end point of the blue line below - unchanged from last month.

So, seeing the heavy influence of OER, the largest, worst behaving component within "core inflation", a reasonable question to ponder is the likely impact of higher interest rates on owner's equivalent rent. After all, if pain is going to be inflicted on the populace in the form of higher rates, there should be a reasonable expectation of a reduction in "core inflation". Shouldn't there?

But, think about it.

In the near term at least, housing is only going to get less affordable with more interest rate hikes since house prices are "sticky down" (or at least that's what they say - we'll see just how sticky "sticky down" really is if rates continue rising).

And, if rates are at current levels or higher next March, when more than a trillion dollars of adjustable rate mortgages adjust upward, then there will likely be even more homeowners who revert to writing a check to a landlord, rather than to a mortgage company.

So what's the rationale for continuing to raise rates to fight this kind of "inflation"?

Wouldn't it make more sense to lower rates, so more renters can become homeowners and existing homeowners can refinance at lower interest rates, removing all the recent excess demand for rental housing, thus forcing OER back to a benign state?

Isn't raising rates now a perfect example of how not to fight "inflation"?