My colleague Ben Carlson asked the question “Why isn’t inflation slowing?” There are some technical explanations, but before we get there, a quick reminder of how we got here:
The global pandemic forced governments around the world to shut down their economies; everything Schools, businesses, restaurants, entertainment venues, retail stores and offices were closed. It was a desperate way to stay ahead of a deadly disease that we barely understood at the time. Finally, we realize that vaccines and masking can help us manage the worst of it.
We approved fast-track vaccines and passed the largest fiscal stimulus in US history – 10% of GDP for the CARES Act I. We survived the pandemic by doing our best at home with Zoom and Teledocs, Peloton and Netflix. We have shifted our consumption habits from services to products; Several of us bought houses and left the dense cities. Global manufacturing systems and supply chains have proven inadequate to accommodate increased demand.
So, a spike in inflation in 2021 will accelerate in 2022.
Once herd immunity is achieved, the world slowly begins to open up again, dare I say it? Many prices are starting to come back down to earth: lumber, copper, used cars, gasoline, oil, nat gas, sugar, beef, avocados, and even chicken wings are down significantly from their peaks. Some products, such as lumber, have returned to pre-pandemic levels.
Yet as Ben points out, the last 7 monthly inflation prints (annualized) have ranged from 8.2% to 9.1%. There is no indication in the producer price or consumer price index that prices are moving “Transitory” looks more like wishful thinking.
As it turns out, a technical aspect of how the CPI is compiled is a big part of the reason. It’s a quirk of how the BLS puts together its CPI model, trying to figure out how to measure shelter as a cost and an asset for millions of homeowners. Understanding this will help you understand why inflation appears to be so sticky, despite the massive decline in prices.
Information that offers a lot goods Prices have risen significantly from pre-pandemic levels but are no longer rising; Indeed, many have fallen dramatically. Commodity inflation seems to have peaked.
that leaf service. The largest segment of services is shelter (by far). In fact, it is the largest component of the CPI, accounting for 32% of the index and ~40% of the core CPI. It is calculated through a complex model called Owners Equivalent Rent (OER).
It doesn’t handle the way you might imagine:
“House prices do not directly enter into the CPI (or Personal Consumption Expenditure) calculation [PCE] price index, for that matter). This is because a home is an asset, and an increase in its value does not impose a “cost” on the homeowner. But homeowners face an expense in addition to home maintenance and utilities, and the implicit rent they incur by living in their home instead of renting it out. In fact, each homeowner is his or her own tenant, and the rent they give up each month is called the “Owners’ Equivalent Rent” (or OER) in the CPI.
—Mike Bryan and Nick Parker, Macroblog, Atlanta Federal Reserve
This model oddity has had a huge impact on inflation over time. Note that the problem with OER is not a new phenomenon and research notes1 Above was from 2013.
I first began discussing the impact of rental costs on the CPI during the financial crisis of the mid-2000s. As more people bought homes, real estate prices skyrocketed, and fewer renters meant rents fell. In the pre-GFC 2000s, house prices were rising rapidly — largely due to reckless lending practices and Rapidly falling mortgage rates.- CPI has actually appeared lower than inflation.
It seems perverse, but so it happened.
Today, we are dealing with a strange reversal of that situation. Home prices are rising, partly due to a lack of inventory but much higher Rapidly rising mortgage rates. These rates are primarily driven by FOMC action. This combination works to price many potential buyers out of the market. But you have to live somewhere, and so these buyers are forced to (or be) renting.
At the heart of sticky CPI inflation readings lies a simple truism:
Higher fed funds rate and mortgage rates = rising OER and CPI
At least, that’s how this cycle seems to be operating.
This leads us to the very perverse conclusion that the Federal Reserve tries to fight inflation by raising interest rates, leading to higher CPI inflation each month. Even the prices of goods have come down.
Worse, the FOMC appears to be relying on the CPI to determine when to stop raising rates, even as they themselves drive those monthly CPI prints higher.
Rent prices are complicated to model, and their calculations are not as simple as surveying different landlords. Instead, it is tied to house prices along with other factors in the OER sub-model. The Bureau of Labor Statistics and the Cleveland Fed are aware of this discrepancy. A recent research paper notes:
“Distinct rent growth indices often give markedly different measures of rent inflation. We construct new indicators using a repeated rent index method from Bureau of Labor Statistics (BLS) rent microdata and show that this discrepancy is almost entirely explained by differences in rent increases for new renters relative to average rent increases for all renters. Rent inflation for new renters leads official BLS rent inflation by 4 quarters. Since rents are the largest component of the consumer price index, this has implications for our understanding of overall inflation dynamics and guiding monetary policy.”
– Brian Adams, Lara Lowenstein, Hugh Montag and Randall Verbrugge
The good news is that the Fed’s research arms and the BLS are aware of this modeling problem and appear to be taking steps to address it. The bad news is, I see no evidence that the Federal Reserve itself has admitted its role in this inflationary mess.
In the wonderful world of economic modeling, CPI has remained persistently high despite falling prices, and we must consider the role of the Federal Reserve as part of the reason.
Did you ever guess that Jerome Powell was going to be one of the greatest agents of inflation?
Why is inflation not decreasing? (Ben Carlson, October 21, 2022)
How Everyone Miscalculated Housing Demand (July 29, 2021)
Why the government took home prices out of its core inflation index (Timothy B. Lee and Aiden Barton, May 11, 2022)
You say you are a home owner and not a renter? Think again. (Mike Bryan and Nick Parker, March 11, 2013)
in the past:
Why is the Fed always late to the party? (October 7, 2022)
Goodbye, TINA (September 28, 2022)
Who’s to Blame for Inflation, 1-15 (June 28, 2022)
Bloomberg: CPI Inflation Data a “Fake” (September 26, 2007)
Disentangling rent index differences: data, methods and scope
Bryan Adams, Lara Lowenstein, Hugh Montag and Randall Verbrugge
US Bureau of Labor Statistics + Federal Reserve Bank of Cleveland, October 6, 2022
1. I thought it was important enough when I saw it mirrored in The Big Picture in 2013.