Low-Balling Inflation Puts the Fed at Risk
The U.S. has an inflation problem. It has nothing to do with inflation being too high or too low. Unlike the raging inflation of the 1970s, it doesn’t need to be solved with a lengthy and painful recession. Instead, it is a problem of measurement because the cost of housing -- the single biggest expense for many Americans -- isn’t explicitly included in the inflation data.
A simple retort is that housing is included in inflation figures by way of what the Bureau of Labor Statistics -- the entity that compiles inflation data -- calls owner’s equivalent rent. Instead of using actual home prices in its calculations, the BLS estimates how much a homeowner would theoretically pay to rent their own home, abstracting housing prices from rental costs. This might not seem like much of an issue. After all, housing is included in the calculation, however imperfectly.
Measuring inflation isn’t a simple task, but it is an incredibly important one. Inflation determines Social Security benefits and pay increases, and mismeasurement has real-world consequences.
The BLS and many economists would argue that because housing is more of an investment (and not a great one historically) than a consumption good or service, home prices shouldn’t factor into inflation calculations.
So why bother arguing to include housing in the inflation data? Recent research from the Bank for International Settlements finds that the transmission mechanism for monetary policy has shifted. In their paper “Monetary Policy Transmission and Trade-Offs in the United States: Old and New,” Boris Hofmann and Gert Peersman concluded that changes in monetary policy -- rate hikes or rate cuts -- are being filtered into the economy increasingly through housing prices and less so via businesses raising prices as in years past. So even though the Federal Reserve’s policies are causing those prices to rise, they aren’t registering in the form of higher overall inflation.
This creates a troublesome landscape for executing monetary policy. The Fed is wedded to a 2 percent annual inflation target without being able to get a reliable read on whether it is accomplishing that goal.
In June, housing prices, as represented by owner’s equivalent rent in the consumer price index, increased 3.3 percent. Compare this to the S&P/Case-Shiller U.S. 20-City Composite Home Price Index, a popular measure of single-family home prices, which increased 5.7 percent.
A difference of 2.4 percentage points may not sound like much, but owner’s equivalent rent is weighted at almost a quarter of the CPI, making this differential exceedingly important to inflation readings. A 3.3 percent owner’s equivalent rent figure contributes about 0.8 percent to the overall inflation reading. Using the 5.7 percent indicated by the Case-Shiller Index, the contribution rises to 1.4 percent, bringing the total inflation rate up to a healthy 2.5 percent.
There are better indexes than the Case-Shiller for imputing the price dynamics of housing. But the implications would be similar regardless of the index chosen -- a more accurate reflection of monetary policy on consumer prices. The Fed isn’t getting full credit for the effectiveness of its policies, and may be led to make missteps as a result.
A more accurate depiction of the CPI would alter the current conversation about weak inflation and reduce the possibility of the Fed losing its credibility. It would also allow the Fed to raise its inflation target to 2.5 percent or higher, giving the central bank scope for more stimulative monetary policy.
At any rate, the sudden recognition of inflation pressures is something the Fed would appreciate given that it has generally failed to meet its 2 percent target in the wake of the financial crisis.
The inflation problem isn’t hard to fix. It requires a recognition that U.S. monetary policy plays a different role in the economy than it did in the past. Housing is now one of the primary ways that policy stimulates the economy. This might not be a good thing, as events of a decade ago would suggest. However, without a proper accounting, there is a greater chance the Fed will make an error because it failed to recognize the true inflationary pressures at work in the economy.
We need to rethink our monetary policy tools, and the channels through which they filter into the broader economy. In doing so, there is also a chance to build better metrics to assess their efficacy. Even though home prices are a primary vehicle for the Fed’s monetary policy, the way they are captured in the inflation calculations marks a serious weakness.
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James Greiff at email@example.com