The idea that the Federal Reserve’s steep interest rate rises actually made U.S. inflation stickier has more merit than it first sounds - not least among U.S. central bank researchers themselves.
The oft-lampooned notion that interest rate rises actually spur inflation usually receives short shrift - and stems mostly from times when mortgage interest payments were directly included in catch-all household inflation baskets.
As the suggestion floated again this week - with JPMorgan Asset Management strategist Jack Manley telling Bloomberg that Fed rate hikes were partly responsible for elevated inflation - social media wags were quick to compare it to the discredited theories of Turkish leader Tayyip Erdogan.
But with U.S. markets running scared of yet another hot consumer price inflation report for March, and with rents and shelter costs key aggravators of that miss once again, elements of the counter-intuitive rates-and-inflation idea may deserve some scrutiny - and calm investors down a bit too.
What’s more, differences between how inflation benchmarks account for housing and shelter in the U.S. and Europe may also go some way to explaining why markets feel the European Central Bank can go ahead and cut rates this June even if they think the Fed may now hesitate.
As pointed out by Eurizon SLJ’s Stephen Jen and Joana Freire this week, the link is rooted in two papers from Fed researchers in recent years.
The first was a discussion paper by economists Daniel Dias and Joao Duarte that was published by the Fed’s Board of Governors in 2019, less than a year before the onset of the COVID-19 pandemic.
The study concluded that “housing rents increase in response to contractionary monetary policy shocks” and that “after a contractionary monetary policy shock, rental vacancies and the homeownership rate decline.”
Put another way, the research showed that rental costs tend to surge as rising mortgage costs force those put off from buying houses to rent instead - while also reducing the number of potential homes to rent.
And reinforcing the peculiarity of the response of rent, the paper showed all other main components of the consumer price index (CPI) either decline in response to tighter monetary policy or are not responsive.
GIMME SHELTER
A second paper last year by San Francisco Fed researchers Zheng Liu and Mollie Pepper pointed out that housing expenditures represent about 15% of the personal consumption expenditures (PCE) price index, a quarter of the services component of PCE and about 40% of “core” consumer expenditures that exclude food and energy. The PCE is the U.S. central bank’s favored inflation measure.
As rent and housing-related costs account for some 34% of the CPI index, the “hot” March reading was down largely to another 0.4% monthly rise in “owners’ equivalent rent” - an imputed measure of the amount homeowners would pay to rent or would earn from renting their property.
The San Francisco Fed paper noted the continued surge in rental prices even following the steep rate hikes in 2022 and 2023, but it said there was evidence that tighter monetary policy tamped down rent prices eventually - with the stickiness due in part to long-term rental contracts.
It argued that a one-percentage-point increase in the Fed’s policy rate would reduce rental inflation by 3.2 points - and headline PCE rates by half a percentage point.
But only after two and half years. So don’t hold your breath.
That would suggest the full effects on rent from the Fed’s initial rate rises in 2022 won’t be felt until the end of this year - even though presumably it kicks in sharply from there given that the Fed’s policy rate is now 5.25 percentage points higher than it was in March of 2022.
SHELTER FROM THE STORM
“Rents and rental inflation should eventually fall, as high interest rates crimp households’ purchasing power,” Eurizon SLJ’s Jen and Freire wrote.
“Rather perversely, early Fed rate cuts could run the process in reverse and help depress rent and, in turn, inflation,” they added. “The general trend in U.S. inflation is definitely down - and in our view all non-shelter components of inflation are either falling fast or are already outright negative.”
Supermarket food prices were unchanged last month and vehicle prices fell, for example.
And even though he said a Fed rate cut was not imminent, New York Fed President John Williams on Thursday stressed core services inflation excluding housing was falling faster than expected.
He also batted away suggestions this month from colleagues, such as Fed Governor Michelle Bowman, that the central bank’s policy rate may even need to go higher still.
And on the basis of the slightly perverse link between rates and rent inflation, another hike at this stage sounds very unwise.
After this week’s CPI scare chased borrowing rates higher across the maturity spectrum - and pushed traders to take all but one quarter-percentage-point cut off the table - perhaps the biggest market risk from here is the Fed is actually more relaxed than many fear.
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