The local dilemma of central banks
It is well known by now that US inflation is stubbornly high. Although lower energy prices eased pressure on the headline consumer price index, the core indicator defiantly accelerated to 6.6% in September (from 6.3% in August) .
Economists have long emphasized the lagged nature of consumer prices, and the measure of housing costs is an apt manifestation of this narrative. Consumer price measures – both the CPI and the Federal Reserve’s preferred personal consumption expenditure (PCE) price index – capture estimated rents for all housing occupants (owners and renters). Unfortunately, the rent inflation trend is moving at a snail’s pace. Because leases renewed at current market rates are rolled into previous leases, it can take up to 12 months for changes in asking rents to show up in the CPI (Chart 1).1 This, in itself, is a problem given that the Federal Reserve’s rollback strategy on inflation has caused financial markets to react to every monthly data report. But the significance of the lag is amplified given that the housing component has, by far, the largest weight in the inflation measure.
This is precisely why central banks have traditionally communicated a 12 to 18 month horizon for the transmission of policy decisions to economic outcomes. Unfortunately, pivoting their message to focus on this horizon may now lack market credibility. That leaves the Federal Reserve likely to have no choice but to overshoot the key rate and flip the economy as it chases back data.
The challenges in Canada are similar when it comes to central bank communication, but with the advantage of having a more cooperative CPI measure when it comes to housing costs. It does not take into account housing costs for owners (the largest share of households) via rents, but includes replacement costs for new housing and mortgage interest costs. Mortgage interest charges represent a small weighting in the index, which helps mask the circular nature of the spike in charges that is a direct result of monetary tightening.
No shelter from the storm
To understand where things are headed, it’s important to take a closer look at the forces behind the shelter IPC. This component represents 33% of the total CPI and 42% of the core index. Some customers have asked if this represents home prices. The direct answer is no. The Bureau of Labor Statistics (BLS) estimates the service provided by the shelter, not the change in home value. For tenants, this is directly observable through rents, but for owners, the CPI captures the “owner equivalent rent” (or OER). The survey tracks what it would cost homeowners to pay to rent their home.
In practice, the OER tends to follow tenants’ rent fairly closely (Chart 2). However, in both cases, the rent entered in the CPI is that of all the occupants of the dwelling. Since most people do not move regularly, changes in CPI rents will tend to follow the changes in rents of new tenants. Indeed, using the rental price index observed by Zillow, rents for new leases accelerated sharply during 2021 and early 2022, peaking at 17.1% in February of this year. CPI rents rose much more slowly. Given the almost 50% weight of housing in the core CPI, if housing prices were measured by the Zillow measure, core inflation would have accelerated faster through 2021, likely reaching lows. double-digit rate, peaking in March and trending significantly downward since (Chart 3).
With new lease prices pushing the housing CPI up nine to 12 months, monthly rental CPI price growth is expected to remain close to its current high levels for several more months. Even if it starts to slow – in line with the evident slowdown in new leases – a nearly 8% year-over-year peak is unlikely to occur until the first quarter of 2023 (Chart 4).
With a heavy component like housing inflation rising, any hope of core inflation falling materially will require significant offsets across the rest of the consumption basket. As a simple arithmetic example, for core CPI inflation to slow to 6.2% in the fourth quarter of this year (from 6.3% year-on-year in the third quarter), the pace of growth monthly prices of non-housing components will be at a quarter of the trend of the last three months. It’s a big challenge.
Inflation is more likely to reverse in the spring of 2023, when CPI rental measures capture the turn in new leases seen today.
PCE measurements are less sensitive to housing
There is good news in store. The stickiness of CPI inflation is less evident in the PCE price measure, where housing has about half the weight. In the core PCE measure, it has a representation of around 17%, compared to 42% in its CPI counterpart.
It’s still heavy, but its lagging nature will have a noticeably smaller impact on the PCE inflation gauge. For example, replicating the exercise above, monthly non-housing price growth will need to operate at about half its pace from the previous three months for core PCE inflation to slow in the fourth quarter.
Between the two measures, the PCE index is preferred by the Federal Reserve as a more accurate reflection of household costs. This means that a widening of the growth wedge will occur between the ECP and CPI measures, due to housing being slow to transform. However, this can still lead to market volatility and undermine inflation expectations, as CPI data is released before the PCE measurement, causing earlier socialization with markets and central bankers. And, given that the central bank has trained the markets to focus on all aspects of near-term inflation data, the PCE metric may have to work much harder or reach lower thresholds to give the market the confidence that a rotation of inflation has power. .
Canada has a similar problem for different reasons
Housing will also play an important role in influencing inflation north of the border, but not for the same reasons. As in the United States, housing is the largest component of the Canadian CPI basket (29.8%). However, in Canada, housing inflation is calculated differently for rented accommodation and owned accommodation. The latter captures the cost of using an owner-occupied home through mortgage interest, replacement cost (based on the New Housing Price Index), property taxes, maintenance and repairs, and other costs. other owned accommodation. Not all of these items fall within the scope of the US measures.
The good news for Canada is that replacement costs and other costs related to owned accommodation are responding better to changes in house prices and have already begun to slow. The lingering concern is mortgage interest charges. Although this is only a small part of the Canadian basket at just under 3%, it is growing at a phenomenal rate (2.8% non-annualized increase in September alone) and should continue to rise. At such a rapid rate of increase, it will add significantly to the core CPI despite its low weighting.
A risky time for central bankers
When central banks began emergency hikes in early spring, the message was clear that forecasting models and judgment had seriously underestimated inflation. It was not only in terms of stickiness, but also in understanding the very sources of the pressure. Confidence around the model’s predictions had eroded as economic forces shifted from an unprecedented pandemic directly into the crosshairs of Russia’s invasion of Ukraine.
It made sense for central banks to focus on observable inflation data, as they sought to restore market confidence and justify the rapid removal of hyper-simulative monetary settings. Now that policy rates have risen at the fastest pace in four decades, we are once again in uncharted territory – this time on the other side of risk. The central bank should soon resume guiding the markets with a more forward-looking attitude. As we’ve said before, using current inflation data to determine the timing and pace of interest rate hikes at every policy meeting is like moving forward while looking in the rearview mirror. Eventually an accident will happen.