More on the Fed, Housing, and Inflation

In the previous post, I reviewed interest rates and Fed policy since the beginning of Covid. In this post (part of which is for subscribers only), I want to follow up on that with a series of questions.

Has the Fed waited too long to stop raising rates?

In the previous post, I asserted that, yes they have, and that it probably doesn’t matter much, as long as they don’t remain too stubborn. As I have been noting for some time, the inflation that matters has been under control for months.

I don’t know if this is useful beyond anything I discussed in the previous post, but Figure 1 is a current breakdown of trailing 12 month inflation.

Figure 1

I went into some reasons why I remove shelter in my analysis in the previous post. Another way to think about it is that what we really should be interested in is production. It is Gross domestic production after all. But, most of the change in rent inflation, especially in the current supply constrained context, has nothing to do with production. It is an extraction by property owners - stationary bandits exacting a toll. Much of the increase in rents is in the existing stock of homes, and has little to do with the original cost of building those homes, or, really, with the cost of building new homes now. Rent inflation is not largely related to the question of how to create a cyclically stable marketplace for production. It is a transfer from non-owners to owners. So, I like to remove it from the measures.

The current 12 month rate of inflation is 5.0%. Looking at the components of 12 month inflation, 1.6% of that 5.0% is excess inflation from before July 2022. That isn’t of concern. That will naturally fall out the back of the measure as we move ahead. If inflation rises again, it will have nothing to do with that. It’s a distraction. That leaves us at 3.4%

Another 2.3% of it is shelter inflation since June 2022. Removing that takes us to 1%. Energy has been deflationary since June, so taking out food and energy to get a “Core minus shelter” measure moves us back up to 2.9%. The future run rate is probably somewhere between 1% and 2.9%. There are items in the “core minus supply” category, like used cars, that should continue to reverse from previous highs. In any case, we are basically at target inflation, and unknown future real shocks will probably be the main drivers of new trends.

Did the Fed need to hike at all?

Again, from the previous post, now that we have enough time to discern trend from noise, it is clear that inflation abruptly slowed down persistently by July 2022. In June, the Fed had raised the target Fed Funds rate from 0.75% to 1.5%, and expectations were for rates to top out at 3%. This presents a plausible case that the neutral rate never exceeded a point in the 0.75% to 3% range. Since inflation settled within months of the first rate hike, there is some possibility that Fed hikes had little to do with the end of excess inflation, and that inflation was truly transitory - having more to do with Covid-related and Ukraine War related supply chain constraints, or possibly one-time Covid-related fiscal policies than with persistent bias in monetary posture.

Did the Fed wait too late to hike rates?

The answer to the previous question suggests that they didn’t. The question really boils down to how much of the transitory inflation was a monetary issue vs. supply chain. One sign of over-stimulus is that by mid-2021, nominal GDP growth had caught up to the pre-Covid trend, and remained above 10% through the end of 2021. It has been on a glide path back to 5% since then, which has been fine with me, but if you view stable nominal GDP growth as a fundamental measure with which to grade monetary policy, there is grounds for complaint there.

I am a fan of nominal GDP growth targeting, but I do think there are still dilemmas in the face of unusual supply shocks. Supply shocks can cause temporary inflation and nominal GDP spikes that aren’t related to overstimulus, and I think it is an open question whether it is optimal to create nominal deflationary shocks in sectors that aren’t affected by supply shocks in order to make up for the inflation in the affected sectors. On the one hand, I think the utilitarian answer is obviously “no”. On the other hand, what is an economy but a series of marginal shifts and changes, which, at any given time, includes some subset that could be described as supply shocks, and so, in real time, it may be hard to make a distinction, and that might create a bias toward 70s style overstimulus.

But, I think, in practice, the Covid period is a clear outlier, and can be treated as an exception. In the past, economic growth has had a surprisingly strong mean reversion, though there are some major negative shocks that created permanent reductions in the trend - like 2008. In the Covid period, it looks like we might have created a positive shock, at least in nominal terms. If we can return to a 5%ish nominal GDP trend after this, maybe it’s “no harm, no foul”. Certainly, I think any monetary criticism that would have called for austerity that would have slowed recovery, increased unemployment, or slowed housing construction at all, should have a tall hurdle to jump to be presented as the optimal counterfactual.

And, my assertion from the previous post is that by waiting to hike and allowing this temporary one-time nominal spike to happen, while maintaining credibility about a return to trend, the Fed has actually raised the neutral interest rate. Long term real rates have not increased because of expectations that the Fed will keep rates above the pre-Covid neutral level (which was probably near zero). They have increased because the Fed has managed its Covid response so well that expectations have permanently improved.

Should the Fed have tried to slow down the housing market?

In 2021 and early 2022, housing was overheated by any definition of the term. There were more buyers than supply. Inventory was bought up. Backlogs became bloated. That allowed builders to charge prices well above cost.