As the nation navigates out of the COVID recession, the high inflation of the 1970s can serve as a useful guide for our monetary policy. Not because today’s high inflation puts us in the same situation, but because the supply shocks in the oil markets of four decades ago have a modern-day parallel.
The 1970s were famously hit with a series of fossil-fuel supply shocks that accelerated price inflation, significantly complicating the job of the Federal Reserve. Some of the recent, headline-grabbing consumer inflation has come from supply-chain disruptions related to COVID-19. While inflation from those disruptions should subside, another recent source of it comes from a more persistent disruption in supply: a lack of adequate housing.
Housing demand is similar to that for fuels: People tend to keep buying even when prices increase. It is, in economic terms, “inelastic.” Today, we have a housing market that is similar to the 1970s petroleum market. In big cities that have clamped down on housing development, locals must keep spending a more painful amount of their incomes on rising rents — or else move to a city that allows more building.
Housing supply was once generous. From World War II until the late 1970s, residential investment rarely claimed less than 4 percent of U.S. GDP. As a result, homes were plentiful and affordable. The rental value of American homes remained less than 9 percent of U.S. GDP throughout that period.
After the late 1970s, residential investment has mostly been below 4 percent of GDP. Just as Americans spent more of our incomes in the 1970s in order to purchase less gas, today, we are spending more for less housing. In most years, rent inflation is now above the inflation rate for other goods and services. Today, the rental value of American housing accounts for more than 11 percent of GDP.
As with petroleum, rising home prices are the result of a lack of supply. But herein lies a crucial difference. In the 1970s, the Fed and federal regulators couldn’t do much to speed up oil deliveries from the Middle East. They can, however, do quite a bit to speed up housing construction, by supporting strong economic growth and generous credit markets.
There is some fear that the return of rising urban rents will make the Fed’s job more difficult in the months ahead, but in fact, the opposite is true.
For a decade, new-home construction has been too low. In addition to rising rents, this has led to reduced migration, slower household formation, and perhaps even slower population growth. The low rate of construction stems from Fed policy choices made before the Great Recession, followed by a decade of tight lending restrictions that made it difficult for young and middle-class families to finance entry-level homes.
By late 2005, convinced by the false notion that we were building too many homes, the Fed was aiming to slow sales of new homes. Construction activity slowed as a result, which was immediately followed by a sharp rise in rent inflation.
Here’s another way to look at it: In the core consumer price index, the housing component can be separated from the nonhousing components. During the twelve months ending in September 2005 — just about the peak of new-home sales — both were running at 1.9 percent annual inflation. By the end of 2006, after housing construction slowed, the housing component was up to 4.1 percent inflation, while the nonhousing components were down to 1.6 percent. That averaged out to 2.6 percent, above the Fed’s 2 percent inflation target.
In other words, by curtailing real investment, the Fed created its own housing supply shock. That created rent inflation, just as the oil shocks in the 1970s led to high gas prices. Then the Fed reacted to its own supply shock by sucking cash out of the economy to bring down inflation. The question as to how much this played into the recession, deflation, and financial crisis that followed deserves more attention.
Turning back to 2021, as economic activity normalizes, inflation in many areas — such as, say, used cars — may prove to be temporary. But rent inflation appears to be headed back above 3 percent, where it had been before the pandemic.
If rent inflation begins to drive the broader price indexes higher while other prices moderate, that is good news. It allows the Fed to encourage more building, which will help moderate rent inflation and create quality construction jobs. This is what the Fed could have done when housing construction declined in 2006 and 2007. At that time, though, the depth of our housing supply problem wasn’t well understood. There is no reason to make the same mistake again. What we need, once and for all, is a monetary policy that is stimulative enough to break out of our housing slump.