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A Tail of Two Inflations - March 19, 2019

“This Is Not Your Father’s Inflation”

In February, we discussed a paper from Adam Ozimek and Michael Ferlez bluntly titled “The Fed’s Mistake”. Their analysis argued that the Fed made an ex-post mistake, where subsequent data proved that the Fed had moved too quickly. Fast forward a month and we have another analysis of the Fed’s error, this time from Daniel Alpert. In “What the Federal Reserve Got Totally Wrong about Inflation and Interest Rate Policy: Getting Real About Rents”, Alpert explains that the Fed’s 2018 moves “were decidedly unwise” and stemmed from “the Fed’s apparent failure to adequately appreciate the change to inflation dynamics that have persisted over the past 15 years”. In short, the Fed hasn’t realized how the housing sector “has dominated the entire subject of price inflation”.

At the root of Alpert’s analysis is the same shift in housing dynamics the St. Louis Fed studied in its three-part series that we discussed back in May 2018. Despite rising rents, and rising demand, market dynamics have resulted in a contraction of supply, causing a spike in owner-occupied home prices. This has in-turn caused housing to dominate both CPI and the Fed’s preferred inflation measure, Core PCE. Now, with rents and home prices threatening to go on an extended decline, there could be “materially lower inflation data in 2019. Far lower that the FOMC was banking on to support its monetary policy actions of 2018”.

However, the danger facing the Fed is more than just a potential lack of inflation pressures. Alpert notes that capacity utilization and low CapEx can filter into the job market, and “with fewer higher quality jobs comes sub-par household income growth and low levels of domestic inflation”, which further reinforces negative housing dynamics. Alpert warns that the Fed needs to “allow for high levels of rent and OER growth to peter out based on factors of supply and demand, before setting off alarm bells regarding the risks of harmful inflation.” If they don’t and are forced to crush inflation (read housing inflation) via a recession, it would be “a classic example of a successful surgery during which the patient dies”.

Alpert’s report covers more than the topics we have summarized here and is well worth reading in its entirety.