Tuesday, December 8, 2015

Inflation and the Fed Funds Rate with supply side inflation

I have posited that housing supply constraints for the past two decades have led to supply-side inflation, and that our inflation indicators have been conflating two factors: (1) monetary inflation, which may be reflected by core CPI inflation, excluding shelter, and (2) supply-side inflation, which is reflected by shelter inflation above that core CPI ex. shelter level.  The supply-side inflation represents rents that are transferred to existing real estate owners as supply constrictions lead to rent inflation.  These transfers are picked up in the data as inflation, and are erroneously attributed to expansive monetary policy.

If one accepts this idea, then I think TIPS markets are giving a pretty strong signal that markets expect either a deflationary shock in the next few years or a Japan-like situation going forward, where core inflation is negligible.  Here is a graph comparing the 5 year inflation expectation implied by TIPS bonds to the Shelter portion of CPI inflation (Shelter inflation x its weight in the CPI calculation).  I don't think the bottom is going to drop out of labor markets in the next three months, or anything, but this seems like a striking picture as we expect an imminent shift to rate hikes.

PS: Here is the difference between these measures.  Note how 5 year inflation expectations minus Shelter inflation declined in 2006 when the housing market first began to sputter, then began to recover when the Fed Funds Rate was finally allowed to decline in late 2007 and early 2008, then collapsed when the Fed prematurely held rates up at 2% in 2008, then bumped up with each round of QE, only to decline again after each QE was tapered or ended, until now, where forward inflation outside of shelter inflation is negligible.



  1. Fascinating post.

    I keep asking this question, and no one wants to answering: "Should QE be considered conventional monetary policy? Should the US run about $50 billion a month in QE indefinitely?"

    The Bank of Japan somewhat says "yes."

    Not a PC topic in central bank circles...

    1. I'm with Sumner on this. If they had done QE1 for another year, they would have already raised rates and wound down the balance sheet. I'd say if they had lowered rates to 0% in early 2008, they might never have needed QE. If they had kept rates at about 4% in 2006, they would never have needed to pull them down to 0%.

      BTW, isn't it weird that the Fed keeps fretting about the size of their balance sheet and how it's unconventional, but then they are proceeding with this new form of rate management that uses interest on reserves, which basically requires them to keep a larger balance sheet? If they are really concerned about the size of the balance sheet, wouldn't they reduce it somewhat before they start raising IOR? The whole thing seems strange to me.

    2. Kevin--The new hip word seems to be "counterfactual" and who knows what would have happened if the Fed had not tightened in 2006, or went looser in 2008, or went more robust with QE1.

      My point is that QE may need to be conventional policy, at least now. I am bewildered that we are not seizing on this opportunity. Monetize federal debt with positive ramifications? Lower taxes? What is there not to like?

      The Fed is doing something now, about $300 billion of "reverse repurchase agreements." This is with financial entities that are not the 22 primary dealers. I am not sure what it means. Maybe you can figure it out.

      The combo of QE and IOER is a strange one. You know, put your pedal on the gas and then the brakes...

      I know you are not a conspiracy buff, but thoughts along the lines of "regulatory capture" are permissible in this case.

      Sheesh, is there a federal agency not captured? USDA? Pentagon? HUD?

      It need not even be nefarious. I am sure there are very sincere people in the USDA, Pentagon and HUD---and in the Federal Reserve---who believe they are acting in the national interest. They develop elaborate rationals, and spend lifetimes in bias confirmation. They become pretty persuasive.

      The Fed developed a program (QE) that placed $4 trillion in assets into the commercial banking system and then started paying interest on those reserves. Are the banks complaining?

      Yes, the Fed still has its obsession with 0% inflation, as measured. That has become a type of religion, a buttressing moral justification for policies, or Theomonetarism.

      Most people and organizations generate moral justifications, and they are necessary for morale. Preserving small farmers, or defending freedom, or holding the line against inflation and hyperinflation and the ruin that would entail, etc.

      Unfortunately for taxpayers and people in the market, the results of federal agency capture are not always beneficial!

  2. Hey guys, interesting discussion. I always think of the Fed as a conspiracy. I think it was a conspiracy to let hot money in and drive up real estate prices and a conspiracy to let the whole thing crash, the latter being harder to grasp for me than the former.

    For example, Greenspan knew this:

    3. Greenspan let easy money loans continue in the S and L crisis. He refused to allow a peek into the derivatives while he was in charge during the big bubble. Those are similar behaviors.

    In other words, Greenspan knew the outcome of toxic loans in the days of the S and L crisis and allowed them to continue anyway. He knew banks would fail, then, so there is no reason for him to believe the same would not happen in the Ponzi Housing Bubble! Greenspan had to know he was putting the financial system at risk!

    1. Gary, I used to think there was a housing bubble, then I thought prices were high by historical standards, but that demand was expressed through market interest rates and thus prices reflected reasonable expected cash flows and market discount rates, and now I think it was a supply issue and that demand had little to do with it, except that policies that destroyed demand created the crisis. See my series of posts on housing for background.

    2. Supply of loans or houses, Kevin? There was, for example, plenty of inventory for sale, just no sales at the end of it all. Yes, demand was expressed through interest rates. They determine everything. My daughter made a little money during the bubble and they offered her an 800 thousand dollar house in Las Vegas, and she told the realtor that she couldn't afford it. Of course, for a time, she could have, until the interest only ended. :)

    3. If you're interested, you should just work backwards through my housing series. Prices rose because of building constrictions in selected cities, then fell because of lending constrictions. Las Vegas was one of a few cities where home prices did seem to become exaggerated for a short period late in the boom.

    4. Ok I will. But Florida prices, Atlanta prices, Central Valley prices, Inland Empire prices, Az prices, and others seemed to be exaggerated as well.