The Fed, Housing, and Inflation

Yesterday's release of the Minutes of the Federal Open Market Committee from last month's Fed policy meeting showed continuing concern over rising prices, members indicating a "substantial risk" that inflation may not decline with a slowing economy.

Members were also concerned about housing, though apparently they're falling a little behind in their reading.

In their discussion of major sectors of the economy, meeting participants focused especially on developments in the housing market. Although the situation varied somewhat across the nation, housing activity was continuing to contract in most regions. Home sales had slowed considerably, and anecdotal reports suggested that more buyers were canceling contracts for purchases. Participants noted that inventories of unsold homes had climbed sharply in many areas and that builders were taking a number of measures to reduce inventories. Both permits for new construction and housing starts had declined significantly. Available measures of home prices suggested that appreciation had slowed considerably but prices in most areas were not falling, although some sellers were reported to be providing various inducements to potential purchasers that reduced effective prices.

Apparently they haven't seen last month's report from the National Association of Realtors where both new and existing home prices have fallen from year ago levels - it was in many of the papers. It's plain to see in the chart from Northern Trust below.
If they're waiting for the third quarter report from the OFHEO (Office of Federal Housing Enterprise Oversight), they'll have to wait another two months. The December report will include a highly anticipated data set as it reflects resale prices of existing homes as well as assessed values for refinancings. This report is generally deemed the most reliable measure of home prices and the December publication could be a doozy.

No one seemed overly concerned about consumer spending - the lynchpin of our modern economy. Maybe they should be. The buoyant effects of increasing household wealth due to rising home prices may be short-lived - not likely to be offset by more jobs and higher wages anytime soon.

In fact, you have to wonder what they're referring to in the first bold, italicized passage below. Lackluster job creation and a fraction of a percent gain in real wages can't be driving consumer spending - it's still all about home equity and easy credit.

Thus far, the drop in housing market activity appeared not to have spilled over significantly to other sectors of the economy. Indeed, consumer expenditures appeared to have been expanding moderately over the previous few months, buoyed by increases in employment, personal income, and household wealth. Contacts in some Districts reported that retail sales had picked up a little most recently. Meeting participants noted that consumer spending going forward would be supported by the higher levels of personal income indicated by recent revisions to the national income and product accounts, by further gains in employment, and by the decline in consumer energy prices over recent months. However, considerable uncertainty was expressed regarding the ultimate extent of the downturn in the housing sector and the degree to which the slowing in housing activity and the deceleration in home prices would affect consumption and other expenditures going forward.

This is going to be a long slow process - opinions about something as dear as real estate are slow to change. This is painfully obvious when reviewing a recent survey in Barron's where it is learned that more than 90 percent of the people surveyed still think that home prices only go in one direction - up.

More than three-fourths of those polled saw their home's value rising over the next few years. More importantly, almost half believe the gain will be more than five percent per year and almost a third believe future gains will top ten percent annually.

Inflation Central

On inflation, there was near consensus that vigilance is still needed. Efforts to tame the cost of owners' equivalent rent have met with some success - it's too bad this is a cost that no one pays. In the view of the assembled board, there is clearly more work to do.

Many meeting participants emphasized that they continued to be quite concerned about the outlook for inflation. Recent rates of core inflation, if they persisted, were seen as higher than consistent with price stability, and participants underscored the importance of ensuring a moderation in inflation. To be sure, very recent data on inflation suggested some improvement from the situation in the late spring, partly reflecting slower increases in owners' equivalent rent. Also, the considerably lower level of energy prices of recent weeks, if sustained, would help reduce overall inflation and damp increases in core prices.

Moreover, businesses would meet more resistance to attempts to pass through cost increases in the less robust economic circumstances that were likely to prevail at least for a time. However, energy prices remained quite sensitive to a wide range of forces, including geopolitical developments, and might well rebound. To date, the available evidence indicated that inflation expectations remained contained--indeed, expectations of price increases for the next few years had fallen some as energy prices declined. Nonetheless, several participants worried that inflation expectations could rise and the Federal Reserve's willingness to carry through on its intention to seek price stability could be called into question if cost and price pressures mounted or even if there was no moderation in core inflation. Looking forward, most participants thought that the most likely outcome was a reduction in inflation pressures, but the anticipated decline was only gradual and the uncertainties around that forecast were skewed toward higher rather than lower inflation rates.

Still wondering how poll respondents can assess future inflation based on anything other than what they see at the gas pump each week, the thought of the Fed's inflation fighting resolve being called into question if the public doesn't see core inflation recede - well, that's just silly.

The decision to hold rates steady in September was easier than in August, a decision that was described as "a particularly close call". Bond prices fell on word that inflation is not yet dead and the expectation of future rate cuts declined.

Meanwhile the Dissenter Speaks

At about the same time that the Fed meeting minutes were released, Jeffrey Lacker of the Richmond Fed spoke before the Washington D.C. Chamber of Commerce on the regional economic outlook. Recall that Mr. Lacker has been the lone dissenter at both of the last two Fed meetings, casting his vote for a another quarter point hike while the rest of the board felt that "no-change" was the correct course.

He made a point to express his discomfort with what he's seen in the inflation statistics lately.

I’ve said on several occasions that I would like to see inflation average about 1.5 percent over time, as measured by our preferred statistic, the price index for core personal consumption expenditures (often referred to as just “the core PCE index.”) Moreover, I have also said that I would be comfortable if inflation was a little higher or lower, coming in between 1 percent and 2 percent. Several other policymakers and economists have also endorsed that range as a functional definition of price stability. But inflation has been outside that comfort zone for over two years now. It was 2.2 percent in 2004, 2.1 percent in 2005, and has come in at a 2.5 percent annual rate so far this year. And inflation looks worse if, instead of using the core PCE index, we were to use the overall index, which includes energy prices. That measure of inflation was 3.2 percent over the last 12 months.

That's funny - inflation looks worse if you include energy.

The official definition of inflation is now clearly two steps removed from reality - first you have the prices that people actually pay for things, then you have the overall consumer price index, and then finally, there is the definition of inflation in the eyes of practitioners of the dismal science - the core rate.

But, there appears to be a breach in the core.

Moreover, the longer inflation remains elevated, the more difficult it will be to bring it back down. As people observe actual core inflation of 2.5 percent, along with the FOMC’s reactions, they adjust expectations regarding future inflation, and those expectations become the basis for price setting in product and labor markets. (By the way, it was for his contributions to economic research on exactly this phenomenon that Professor Edmund Phelps was awarded the Nobel Prize in economics a few days ago.) If the Fed were to allow inflation to remain above target for too long, inflation expectations could become centered around the higher rate. Once that occurs, history tells us that strong and more costly policy actions would be needed to bring inflation and inflation expectations back down. We don’t have any perfect measures of inflation expectations, but what we do have suggests that market participants do not foresee a rapid fall in core inflation. This is why I have argued for further policy actions to convincingly restore price stability.

Economists really are a naive lot. For some reason they think that market participants are tuned into the whole idea of core inflation, and that somehow this is an indication of whether or not the Fed is doing its job? While we can all dream of inflation only being around two percent, that appears to be a concept that exists only in Fed studies and classrooms.

Someday, people will realize what is happening to their money, and if this survey is any indication - a survey that shows the number one worry people currently have is rising prices - that day may be sooner rather than later.