Wednesday, August 29, 2007

Federal Reserve Blind to Housing Bubble: BLS OER V. Case Shiller HPI

Flawed Fed Interest-Rate Policy Based on Rent Inflation, Not House Inflation, Causes Vicious Cycle

Fed Policy: First Identify a Problem . . .

Bloggers for years recognized the housing bubble because house prices diverged from rents. The Fed's John Krainer and Chishen Wei used Federal Housing Enterprise Oversight (OFHEO) data to document the inflated price-rent ratio in 2004 (before the mania of 2005-2006). They argued that expectations of future home-purchase returns drove the divergence but strangely added that "other factors, such as bubbles, do not appear to be empirically important for explaining the behavior of the aggregate price-rent ratio" (Federal Reserve Bank of San Francisco, FRBSF Economic Letter 2004-27, 10/1/04)--even though bubbles are driven by their identified cause, expectations of future returns.

. . . And then Ignore the Problem

The Fed likes to target "core inflation" (without volatile food and energy prices) which uses the Bureau of Labor Statistic's (BLS) Owners' Equivalent Rent (OER). The OER estimates the hypothetical rental value of an owner-occupied, non-rented home and therefore ignores the house's actual purchase price and PITI (Price, Interest, Taxes, Insurance) carrying cost.

Price-rent diverged and the Fed followed the red herring (rent, instead of purchase cost in an "ownership society").

Vicious Cycle of Inflation

The vicious cycle is that the Fed's loose monetary policy through low interest rates causes the housing bubble inflation, but the Fed watches a core-inflation statistic that ignores the house-price inflation it causes, so the Fed underestimates real inflation and keeps interest rates too low, which continues to feed the inflation that is invisible to the Fed.

The Fed is willfully blind because the bubble economy is government policy.

The Fed Is Always a Day Late and a Dollar Short

The Fed's recent bailout of speculators and buttressing of overpriced assets (by lowering the effective Fed funds interest rate and officially cutting the discount-window interest rate) shows that it still ignores the excess inflation that it has caused and is causing.

Wanted: Regression to the Mean

Tim Iacono at Seeking Alpha posted good background on how substituting the Case-Shiller Home Price Index (HPI) Composite 10 for the OER would expose some of the real inflation caused by Fed policy. Iacono however erred by suggesting that the Fed should cut the Fed-funds target rate now because of the recent decline in real-estate prices (deflation). Iacono looked at year-on-year rates but forgot about the magic of compounded inflation rates (like compound interest) from years of misguided monetary policy.

The graph below uses Iacono's chart data (including his core CPI reference, although the Fed tends to watch the Bureau of Economic Analysis' (BEA) core Personal Consumption Expenditures Price Index (PCEPI), which cuts the OER weight in half to 19% of the index) to show that the accumulated inflation from 2000 through 2006 is triple the level that would have occurred at the Fed's stated, desired target of annual 2% core inflation (even the PCEPI-HPI would show real inflation at double the Fed's target).

We now need real price deflation to counteract years of over-inflation and return the economy to a reasonable trend line. Cutting the benchmark Fed funds interest rate (or any other action to increase liquidity) would preserve or expand the over-inflation. If anything, today's monetary policy is still too loose and today's interest rates are still too low--as the markets keep trying to tell the Fed through rises in the effective Fed funds rate.

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