June saw the third straight month-over-month surge in inflation, with the year-over-year rate at 5.4 percent and core inflation (excluding gas and energy prices) reaching 4.5 percent. The month-over-month core inflation rates make the inflationary acceleration picture look even bleaker, as month-over-month measures have been running at a rate not seen since the early 1980s.
Economic policy-makers have explained away these data by pointing to short-term pandemic-related phenomena such as higher used-truck and used-car prices (which make up about one-third of the increase) or “base effects,” that is, inflation is rebounding after falling to a low level in March 2020. In short, the argument continues to be made, albeit with a little more hesitation than before, that this new inflation uptick is “transitory.” Adding some strength to this case, other measures of inflation such as the “trimmed mean” and “median” inflation rates published by the Federal Reserve Bank of Cleveland, which remove outlier items such as those used cars and trucks, show much lower inflation rates (2.90 percent and 2.21 percent year-over-year rates, respectively).
While it’s likely that used-automobile prices and other pandemic-related distortions will ease before too long, price pressure from another sector of the economy could have a tremendous impact on inflation going forward — namely, housing. Over recent months, we have seen enormous increases in housing prices almost to the tune of 15 percent year-over-year, according to the Case-Shiller home price index.
However, because of the way that housing is incorporated into inflation measures, these increases have yet to make a significant mark on inflation data. Housing prices themselves are not included in inflation. Instead, the Consumer Price Index (CPI) measures the cost of shelter, which falls into two elements, actual rents, and something known as owners’ equivalent rent of primary residence (OER). The OER is found by determining how much rent could be charged for an owner-occupied home. “Shelter” makes up as much as 33 percent of the CPI basket published by the Bureau of Labor Statistics.
Why hasn’t it appeared yet in the inflation data? History suggests there’s a lag between housing prices and rent increases by roughly five quarters (i.e., rents are “sticky”). An increase in rent prices of only a few percentage points could point to sustained inflation going forward and change the “transitory” inflation narrative. Prediction markets now pricing in a 61 percent chance of month-over-month inflation above 0.6 percent in July. Housing offers a good example of how monetary policy affects the “real” economy. Raising interest rates too soon could stem mortgage borrowing and dampen housing markets, potentially causing a housing crash, with all the damage that can ensue (as seen in 2008). Many blame the Federal Reserve for raising the federal funds rate in 2006 as one contributing factor to the global financial crisis. They argue that high interest rates disincentivized home buying (since higher mortgage rates make it harder to buy a home), which then led to a larger crash. Unfortunately, it’s the poor who get hurt when the housing market collapses. As economists Amir Sufi and Atif Mian show in their classic book House of Debt, it was people in the lowest income quintiles who saw the biggest damage to their net worth during the Great Recession, because they tend to borrow the most mortgage debt (as a fraction of their income), and a disproportionate amount of their wealth is concentrated in housing compared with the rich.
It’s also important to remember that inflation disproportionately hurts the poor as well. Goods and services bought by those in lower income quintiles experience higher rates of inflation, as economist Xavier Jaravel has shown. On top of that, the poor spend a greater fraction of their income on consumption, meaning the purchasing power of their total income declines much faster, especially when real wages turn negative as they are now.
How soon the Fed will roll back monetary accommodation and raise interest rates largely depends on how the inflation picture pans out. It’s possible that inflation could fall back toward the Fed’s 2 percent long-run inflation target on its own after pandemic-driven supply shortages wane. (It should be noted that, in August 2020, the Fed adopted a “flexible average inflation target,” which means that rather than targeting 2 percent inflation at all times, it instead can deviate from that target for a while as long as 2 percent average inflation is achieved over some undefined period of time.)
However, even as those transitory effects fade, it’s possible that rising housing prices will operate to maintain the inflationary pace and contribute a sustainably higher inflation rate. The longer inflation remains elevated, the more likely it is that inflation expectations become “unanchored” (that is, individuals on the margin no longer believe the Fed is committed to its inflation target), leading to self-sustaining inflation at a rate well above where the Fed would like it to be.
If this turns out to be the case, at some point the Fed will realize a need to fight inflation, begin tapering asset purchases, and signal less accommodative interest policy in its forward guidance. Fed chairman Jay Powell has suggested he is committed to this data-dependent approach (balancing inflation concerns along with full employment as the Fed’s dual mandate requires) and will likely pursue this path, assuming he is able to secure another appointment as chairman (betting markets as of this writing predict Powell has about an 80 percent chance of being reappointed by President Biden).
One way or another we’ll get back to target inflation; one path just requires a very different policy regime (e.g., ending asset purchases faster and raising rates sooner). And that path will depend greatly on how other inflation dynamics, notably housing, play out. Even the New York Times agrees, singling out the cost of shelter as something to watch.
The Gray Lady is not always wrong.