San Francisco homes.
PIXABAY
The Federal Reserve is probably correct in dismissing the sharp jump in inflation reported Wednesday as “transitory.” At the same time, it is ignoring the undercounted but more important factor lifting the price level: housing.
Stock and bond markets tumbled further after the Labor Department reported a much-bigger-than-expected jump in the consumer-price index for April, up 0.8% overall and 0.9% for the “core” measure that excludes volatile food and energy costs. Those were the biggest monthly surges since 1995 and 1981, respectively, and multiples of the increases that economists had predicted.
More important than that one-month surge, the year-over-year increase in the headline CPI jumped to 4.2%, while the core CPI accelerated to 3.0%. A month earlier, the year-over-year increases were 2.6% and 1.7%, respectively. That sharper pace of annual increases in part reflects the so-called base effects of the deflationary collapse at this time in 2020 during the darkest days of the Covid-19 pandemic.
While most headlines concentrated on the outsize jumps in such items as used cars (up 10% in the month given the widely reported dearth of supplies), the acceleration in April’s CPI actually was dampened by the way the Bureau of Labor Statistics calculates housing costs. “Owners equivalent rent”—a convoluted estimate of what homeowners think they would pay to rent their own houses—was up only 0.2% last month and 2.0% over the past 12 months.
That means owners’ equivalent is running a full percentage point below the core CPI’s annual rate of increase, Joseph Carson, the former chief economist of AllianceBernstein, points out in his latest blog. This key measure of the cost of living accounts for roughly one-third of the core CPI, so it has a huge weight in this widely watched gauge.
In 1995, the last time core CPI was running at a 3% year-over-year pace, owners’ equivalent rent was rising at 3.5%. “So the rise in core inflation in 2021 is much broader than what happened more than two and half decades ago,” he writes
Moreover, this contrived measure of shelter inflation fails to capture the actual surge in housing costs, a point Carson has been making forcefully. “Housing prices are up 18% in the past twelve months, a record increase; nine times the increase in owners’ rent,” he points out.
Formerly, the CPI included house prices rather than the nonmarket estimate of owners’ rents. On the old basis using market price, the year-over-year rise in CPI would have been twice the reported 4.2% increase, he adds.
One unappreciated aspect of the surge in inflation is how it is making Federal Reserve policy easier by one criterion. One gauge of monetary policy is the level of interest rates after inflation. “By maintaining the zero rate policy in the face of sharply rising inflation, monetary policy has been even more accommodative,” Carson writes. At the same time, the Fed continues to pump up housing by buying $40 billion of mortgage-backed securities a month along with $80 billion in Treasuries.
Similarly, the bond market’s forecast of inflation is also on the rise. That can be seen in the so-called break-even rate, calculated by the difference of the Treasury yield and the corresponding TIPS (Treasury inflation-protected securities.) For the 10-year maturity, that break-even inflation is 2.67%, the highest since 2005, according to the Federal Reserve Bank of St. Louis.
The 10-year Treasury note traded up to 1.69%, returning to the upper end of its recent range touched in late March. The prospect of further rises in bond yields also brought the S&P 500 back to its lowest level since April 1.
Clearly, the markets’ main concern is the rising inflationary trends will force longer-term interest rates higher and take equities down from their recent peaks. The Fed, for its part, has stated it tolerates and indeed welcomes the higher inflation to make up for previous shortfalls from its 2% target and to restore full employment.
A rise in bond yields over 3% in the 10-year Treasury note in late 2018 nearly tipped stocks into a bear market. But given the explosion in debt throughout the economy since then, it may take a smaller rise in yields to hurt stocks this time. The surge in inflation could lift the benchmark 10-year to the 2% mark that’s been widely forecast.
Whether that will be the tipping point for stocks is a big question mark.
Corrections & Amplifications
The 10-year Treasury note traded up to 1.69%, returning to the upper end of its recent range touched in late March. An earlier version of this column incorrectly gave the yield as 2.69%.
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