Including current housing costs, rather than the lagging data from the CPI, shows that the U.S. is currently in deflation.
Including current housing costs, rather than the lagging data from the CPI, shows that the U.S. is currently in deflation.
T he United States is now in deflation.
That’s not a misprint. It may sound incongruous to the experience of shoppers who have last year’s, or pre-pandemic, prices as references, and to followers of year-on-year statistics who’ve just seen a 6.3 percent CPI figure for January, but year-on-year statistics are irrelevant to today’s circumstances. To recognize deflation, it is necessary to study recent monthly CPI figures.
The U.S. is in deflation when current housing-market prices are incorporated into inflation figures. The CPI converts housing costs, including for owner-occupied homes, into rental equivalents. That’s to reflect the consumption costs of living in a home and not the investment costs of buying one, since the CPI is supposed to measure consumption. CPI housing costs are reported for all home residents, so, since rents typically adjust once a year, each month of CPI data reflects an average of one-twelfth of the change in current housing-market costs. CPI housing data thus lag the current housing market by about a year.
The chart below compares Bureau of Labor Statistics CPI housing costs, known as “rent of shelter,” with an index of housing rental costs from Zillow.
The chart shows that Zillow’s yearly average closely parallels monthly BLS figures (with their twelve-month lag) preceding the pandemic, and that Zillow’s monthly numbers are much noisier, partly from seasonality. Following the pandemic, both monthly and annual Zillow figures jumped much earlier and higher than BLS data did, which is continuing to rise as the Zillow numbers decline sharply.
For the three months ending in January, BLS data show housing costs rising 9.2 percent compared with a decline of 4.7 percent for Zillow rents. Which figure more accurately reflects housing-market conditions that policy-makers should respond to?
Housing constitutes about 32 percent of the total CPI figure and 42 percent of core CPI, which excludes volatile food and energy prices, so the lagged housing-data impact is large. The next chart shows CPI data adjusted to current housing costs with the Zillow data.
Adjusted for current housing costs, both headline and core CPI data take off much earlier and higher following the pandemic than BLS-reported figures do. For the last three months, headline and core CPI figures adjusted for current housing costs are -1.0 and -1.1 percent respectively, indicating deflation. (PCE data for January won’t be out until the end of February, but they average -1.0 and 0.6 percent for headline and core in November and December, which still indicate deflation and are well below the Fed target.)
While official statistics don’t yet reflect housing-cost declines, the Fed is well aware of them and of deflation in goods prices, which have declined 2 percent annualized since July 2022. But, to achieve its overall inflation goal, the Fed is focused on service prices and the wage increases that drive them.
This focus on wages is misplaced because wages lag, they don’t lead, overall inflation. Wages just now are catching up to inflation and should run above it to equalize shrunken compensation from earlier inflation before they stabilize. It would be misguided to suppress this normal progression. The table below contains correlations at different intervals between core CPI inflation and hourly earnings.
Over comparable intervals, CPI figures and hourly earnings are highly correlated, but past CPI correlates strongly with future hourly earnings, while the correlation of past hourly earnings and future CPI is weak at six months and negative at the two-year horizon.
By targeting wages, the Fed is thus delaying its policy response by more than a year and a half — a year for housing costs to filter into inflation data and at least six months for inflation to be reflected in wages. To minimize or avoid a possible recession, the Fed needs to be much timelier than its laggardly response to the pandemic inflation was. In the end, the Fed has no control over which sectors experience inflation; consider, for example, the initial pandemic-era surge of goods inflation.
It will help the Fed to stop fighting the financial markets and start listening to them. Since Chairman Jerome Powell’s Jackson Hole speech in August 2022, the Fed has jawboned rates up to bring about a slowdown and ease inflation, but the markets are well ahead. They know that the precursors of pandemic inflation, the dollar, deficits, and the surge of goods consumption, have reversed. Eventually, housing deflation will show up in official data, and the Fed will then panic to ease conditions as inflation sinks below target. The current long-term expectations for the Fed’s preferred PCE measure of inflation is that it will come in slightly below its 2 percent target.
Fed representatives repeat an old guideline that interest rates should be above the inflation rate, but they ignore the fact that expected inflation is below last year’s figure, and, thanks to their bloated balance sheet, we are not in a textbook world. The Fed’s own research demonstrates that its large balance sheet suppressed yields by 1 percentage point following the financial crisis. Now, its balance sheet is 50 percent larger relative to GDP, so a commensurately greater shift in prevailing rates and yields is expected.
Current circumstances are reminiscent of the Fed’s tightening in fall 2018. Chairman Powell stated we were a long way from neutral with the federal funds rate at around 2 percent, and CEOs of J. P. Morgan and BlackRock echoed the sentiment. In the end, the muckety-mucks were wrong, and the market was right. Any speculations on the outcome this time around?
Had the Fed focused on current market inflation rather than lagging statistics, it could have more effectively responded to pandemic-era inflation. It needs to do so now and pause with a pivot soon.