The Federal Reserve finally confesses to the mistakes made in inflation measurement ( CPI and PCE) via the use of fantasy rents

The economic story of 2024 has been one of several false dawns on US interest-rates. When we began the year there were expectations of at least one interest-rate cut by now and if the second had not happened it would be on its way. That has been replaced by a reality of a first quarter where the improvement in the inflation figures stalled and we have seen not only no interest-rate cuts but also a mention or two of a rise. Yesterday the Federal Reserve Vice Chair Phillip Jefferson spoke and I note this.

“This feels consistent with the idea that the Fed leadership is looking at September as the potential date for the first cut provided that a more definitive and sustained downshift in inflation emerges over the coming months,” Evercore ISI economists said in a flash note. ( Investing.com)

So we are looking at September now? Let us take a look but before we do it was kind of the Fed Vice Chair to confirm I have been right all along about Imputed Rents.

The primary reason for this lag is that market rents adjust more quickly to economic conditions than what landlords charge their existing tenants. This lag suggests that the large increase in market rents during the pandemic is still being passed through to existing rents and may keep housing services inflation elevated for a while longer.

This explanation is required because those who have supported what I call fantasy rents ( assuming owners pay rent) find themselves having to explain how it has gone wrong. It was supposed to be just fine according to their theories but the reality is that US rents fell maybe as far back as 2022 but their whizzbang theory has failed to pick that up. This matters because nearly a third of the US CPI is rents both actual and assumed. There is a particular irony in that the theory which was supposed to produce lower inflation readings is presently producing a higher one.

In this figure, notice that increases in market rents, the blue and red lines, peaked in 2022, and PCE housing services inflation, the black line, lagged market rents and peaked in 2023.

Actually the Fed Vice Chair was also kind enough to confirm another theme of my work.

In closing, let me reiterate why we care about housing. The housing sector is where many households have made, or will make, their largest investment. Therefore, the prices that families pay for that housing can affect their overall well-being.

The emphasis on the latter sentence is mine because I am sorry to have to tell you he is also trying to mislead you. The inflation measures he looks at ignore “the prices that families pay” as they do not include house prices or mortgage rates. In fact he has just confessed it with his section on Imputed Rents. I also note he managed to avoid mentioning one of the central tenets of central banking the claimed Wealth Effects.

The housing sector is also a key part of the transmission mechanism of monetary policy. That is one reason why policymakers will continue to pay close attention to this vital sector.

Mortgages

Actually the Fed Vice Chair made a rather strong case for mortgages being in a cost of living measure.

 Despite higher rates, households in the U.S. borrowed over $1.5 trillion in new mortgage loans in 2023.

That is a lot of money and will have economic effects.

The cumulative effect of a higher interest rate on aggregate mortgage payments grows over time as more new loans are originated at the higher rate. The staff’s research documents that, historically, borrowers like these who are not deterred by higher rates are responsible for a little over half of the pass-through of interest rates to mortgage payments.

Yet he and others have continued for years and indeed decades with the Imputed Rents scam. When in the real world there are large flows of money via mortgages which he is claiming as a success for his policy but simultaneously wants to ignore. It is really shameful as the ordinary person will not now this and with journalism becoming an ever declining profession it is less likely to be challenged.

Just for the avoidance of doubt the central bank should have a measure both with and without mortgage rates. So that they can see the cost of living explicitly as well as avoid a feedback loop for interest-rate rises. It seems obvious but the Bank of Canada mandate got it wrong.

Interest-Rates

In a way we have already covered one avenue for future interest-rate cuts which is that inflation measurement flaws are presently boosting the recorded rate. Indeed the lags issue goes further as we recall the biggest one was the claim by central bankers was that inflation would be Transitory. Which he puts like this.

 Considering the lagged effects of monetary policy, I am encouraged that over the past two years, we have made good progress toward our dual-mandate objectives.

As to the claim of a September move I am less convinced as I note this.

The April consumer price index and producer price index data point to a more modest increase last month. Even so, Federal Reserve staff estimate that core PCE prices rose at an annual rate of 4.1 percent over the first four months of the year. That is well above the 12-month change, which we estimate at 2.75 percent.

As you can see he is pointing out that the measure he looks at has been disappointing in 2024 so far. A theme he continues here.

It is too early to tell whether the recent slowdown in the disinflationary process will be long lasting. The better reading for April is encouraging.

Comment

This is a very interesting speech but mostly not for the reason that many will read it! In terms of interest-rate policy he is being cautious and the September claim from Evercore ISI relies on a very favourable following wind. Those of a more cynical persuasion might consider it a low-risk view for them as in if they are right they can take the credit but if they are wrong the debate will have moved on and few if any will recall it.

But the implied view on inflation measurement is much more interesting. If Phillip Jefferson wants to re-open the debate he deserves some credit. However it is more likely that this is part of the establishment policy of denial. In such moves we see speeches which get close to the truth ( so they can be quoted later) but never fully as that would have people questioning why the “experts” have been proven to be wrong again.

I will be discussing this issue at the Better Statistics conference on Thursday. There is a fee to attend in person but you can logon online for free.

https://www.betterstats.net/inflation-2024-are-we-using-the-right-measures-2/