Perhaps what we’re now witnessing is the end of a period of relative macroeconomic stability that began in the 1990s.
History is not on its side, and soaring housing prices should cause great concern.
I nflation is slowly becoming entrenched in the U.S. economy after heavy government spending and monetary policy that was too loose for too long. Americans now view inflation as the top problem facing the U.S., and even among the economics intelligentsia, former Fed chairman Ben Bernanke has criticized current Fed leaders for being too slow to react to inflation in his new book, 21st Century Monetary Policy.
There are important signs that inflation is becoming entrenched, and they chiefly stem from rising rents in the housing sector. Even though year-over-year headline inflation has fallen in April to 8.3 percent from 8.5 percent the month before, and core inflation has ticked down to 6.2 percent from 6.5 percent a month prior, month-over-month data give us a much clearer picture of whether inflation is continuing to rise at a sustainably higher rate. While the month-over-month measure of headline inflation fell, the month-over-month measure of core inflation, which removes food and energy prices, continued to rise at the historically high rate of 0.6 percent as many permanent components of core inflation, chiefly housing, are continuing to rise.
Housing prices are a big part of what’s happening, and unfortunately their high levels seem to be sticking around. The data appear at something of a lag as rent increases tend to lag housing-price increases (which have risen by approximately 20 percent nationally in the U.S. over the past year).
As I’ve mentioned before, the BLS Consumer Price Index (CPI) basket does not include housing prices but instead only includes rent (and owner equivalent’s rent). This is because the BLS aims to capture only consumption in CPI and views housing units as capital or investment goods. Spending to purchase and improve housing units is considered investment and not consumption while shelter/rent, the housing-service component the housing units provide, is the relevant consumption item for the CPI. These housing services make up about 34 percent of the CPI and about 40 percent of core CPI (when excluding food and energy). Both owners’ equivalent rent and rentier rent has remained at a sustained 4.8 percent year-over-year increase (0.5 percent month-over-month) through April, driving the sustained increase in overall inflation, while things such as used-car price increases are dissipating.
Ultimately, cooling the rise in housing rents will be the key task to bring core inflation back to the Fed’s 2 percent target. There are many potential unfortunate consequences of having to perform such a necessary correction to inflation.
Inflation is generally higher for the poor, as the new FREOPP Inflation Inequality Indices (derived from official BLS data) show. At the same time, raising interest rates will cool demand broadly, especially for the housing market and other sectors as higher interest rates discourage borrowing. Cooling the housing market can have many detrimental effects on the poor as the net worth of those at and below the median income is disproportionately in mortgage-financed housing (as Atif Mian and Amir Sufi’s book House of Debt famously shows). This means that many poorer individuals who recently bought homes using significant amounts of mortgage debt (with high loan-to-value ratios) could see their net worth wiped out if interest-rate tightening created a significant housing-market sell-off.
Significantly higher interest rates and slower demand also mean potentially causing a recession, which would cause unemployment disproportionately among the poor. How severe such a housing-market crash and labor-market downturn will be after the Fed starts raising rates will ultimately answer the question of whether the Fed can reasonably engineer a “soft landing.” History, though, is not on the Fed’s side. Almost every tightening cycle in the post-war era in response to inflation has ended in recession.
All U.S. recessions in the post-war era have been the result of either Fed interest-rate hikes, financial-asset bubbles bursting (think the early 2000s tech bubble and late 2000s housing bubble) or a pandemic (as in 2020). Recessions caused by the Fed correcting its past mistakes are the most common type of recession in the post-war time series, although we haven’t seen such a recession since the early 1990s.
Perhaps what we’re now witnessing is the end of a period of relative macroeconomic stability that began in the 1990s. If it is indeed over, it may have ended thanks in part to policy-makers buying into folk narratives about “transitory” inflation that have put the Fed in a place where for over a year it failed to act in response to rising inflation. Let’s hope this is not the case as much as history might say otherwise.