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Fed Hubris: Housing Prices Show the Fed is Making the Same Inflation Mistake

The Fed is repeating mistakes it made in the dotcom and housing bubble decades. A series of housing-related charts will explain.
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Case-Shiller Home Price Index Levels

Case Shiller Home Price Index as of  2021-12

Here We Go Again

The Case-Shiller Home Price indexes (a measure of repeat sales of the same house) show that home prices are more extended now than ever before.

Those price levels are from December 2020.

Not Understanding Inflation

On February 10, Jerome Powell gave a speech on Getting Back to a Strong Labor Market

In his speech, Powell said the Fed "will likely aim to achieve inflation moderately above 2 percent for some time in the service of keeping inflation expectations well anchored at our 2 percent longer-run goal." 

On February 24, Powell Dissed Inflation and Ignored Questions From Congress About Leverage

On March 4,  I commented Powell Confirmed Easy Money Until the Cows Come Home.

Meaning of Stable

But why 2%, not 1% or 0%? Certainly 2% is not "stable" by any reasonable definition. 

Regardless, to make up for past inflation allegedly being lower than 2% Powell repeated his pledge to let inflation run above 2%. 

Is inflation lower than 2%? As measured by the CPI, it is. But the CPI is a terrible measure of inflation.

It ignores all asset bubbles, it ignores housing prices, and it seriously underweights medical expenses.

Medical Expenses

The CPI seriously underweights medical expenses by averaging in Medicare and Medicaid. 

Healthcare services make up 17.75% of the PPI but only 6.97% of the CPI.

Ask anyone who buys their own medical insurance how fast rates are really rising.

For discussion please see Healthcare is the Biggest PPI Component With Over 3 Times Energy's Weight

With that, let's return our spotlight to housing. 

Housing Disconnects From Rent and the CPI

CS National, Top 10 Metro as of 2020-12

Prior to 2000, home prices, Owners' Equivalent Rent (OER), and the Case Shiller national home price index all moved in sync.

This is important because home prices directly used to be in the CPI. Now they aren't. Only rent is. Yet, OER is the single largest CPI component with a hefty weight of 24.05% of the entire index. 

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The BLS explains this away by calling homes a capital expense not a consumer expense. 

However, that explanation ignores easily observed and measurable inflation. And it's inflation, not alleged consumer inflation, that is important as the following charts show.

Percent Change From a Year Ago Comparison

CS National, Top 10 Metro Percent Change as of 2020-12

Year-over-year, the CPI is only up 1.4%. The OER is up 2.0%, but the Case Shiller National Home Price Index (December) is up a whopping 10.3%.

If we substitute actual home prices for OER in the CPI (as the CPI used to be calculated), the next chart shows what the CPI would look like.

I call the substitution Case-Shiller CPI (CS-CPI).

CPI, CS-CPI Year-Over-Year

CPI, CS-CPI Percent Change as of 2020-12

The BLS says the CPI is up only 1.4% from a year ago. 

However, the CS-CPI has been running between 2% and 3% for the past three years and most of the past seven years. By this measure, the Fed has already achieved its goal

Yet, the Fed is holding rates near zero and has pledged to remain that way.

We can calculate "Real Interest Rates" by subtracting measures of inflation from the Fed Funds Rate.

Real Interest Rates

Real Interest Rates CPI as of 2020-12

Thanks to the Fed slashing interest rates to near-zero, real interest rates are -3.45% as measured by CS-CPI but "only" -1.31% as measured by the CPI.

Third Great Fed Mistake

Brian McAuley comments This Era May Come to Be Remembered as the Federal Reserve’s Third Great Mistake

With the real interest rate at -3.45% is it any wonder speculation in stocks, junk bonds, and housing are rampant?

This is the same mistake the Fed made between 2002 and 2007 when it ignored a blooming housing bubble with dire consequences culminating in the Great Recession.

BIS Study on CPI Deflation

Note that a BIS Study finds that routine consumer price deflation is not damaging in the least.

Specifically, the BIS concludes "Deflation may actually boost output. Lower prices increase real incomes and wealth. And they may also make export goods more competitive!"

Worst of all, in their attempts to fight routine consumer price deflation, central bankers, led by the Fed, create very destructive asset bubbles that eventually collapse, setting off what they should fear – asset bubble deflations.

Mish

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