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 That has been replaced by a reality of a first quarter where the improvement in the inflation figures stalled and we have seen not only no interest-rate cuts but also a mention or two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/

 

There is nothing going on but the rent

The issue of rents has become an even more important one post the Covid pandemic. It has been quite a feature of modern life and along the way has exposed some of the official attempts to mislead us about inflation. Ironically official measures of inflation have in fact used rents far more than they should vi the use of what is called Rental Equivalence although most will call then Imputed Rents. For example the US CPI has around four times as many rents in it as exist in the US.

Now let me switch to the issue of rental inflation being under recorded in my home country the UK and we can start with an example from this morning. The emphasis is mine.

The London rental market has started to “normalise” after a year of short supply and record recent increases in rents, according to Foxtons, with fewer prospective tenants chasing each listing. ( Financial Times)

Those who follow my work will know that I have been regularly pointing out that private-sector measures of rents have been rising at double-digit rates and that this has been missing from the official numbers. As you can see Foxtons have been recording record rises in rents which is good for them but bad for the renters struggling with the cost of living crisis. The reality is that it has not been just London as the BBC has been reporting.

Towns within commuting distance of major cities have seen some of the biggest rent rises of the last three years, new research suggests.The cost of new lets rose by more than a third in areas such as Bolton and Newport between 2020 and 2023, property portal Zoopla said.Although Glasgow, London, Manchester and Edinburgh also saw big rises, new working patterns have made an impact.

The BBC report highlighted Bolton.

But they were led by Bolton, where:

• Rents for new lets were up nearly 39% in the three years to the end of 2023
• The rise of nearly 15% last year alone was the biggest of any area on the list.

The situation there is described like this.

There have been multiple offers on every single property,” said Stuart Matthews, managing director at Miller Metcalfe estate and lettings agent, based in Bolton.

“The price can be put up by £100 a month, and it still goes.”

Having been in the business for 23 years, he described the last 18 months as “staggering” and unlike any other time he knew.

Actually if you look at the BBC figures you see that rents have soared in cities as well with Glasgow posting the highest rise of all at 38.9% over the three-year period. London and Manchester are up there too and the UK has an average of 30.7% over the three-year period. So at this point we are singing along with the Gwen Guthrie song I used in the title.

‘Cause ain’t nothin’ goin’ on but the rent
You got to have a J-O-B if you wanna be with me
Ain’t nothin’ goin’ on but the rent
You got to have a J-O-B if you wanna be with me.

The Official Numbers

The latest numbers are below.

Private rental prices paid by tenants in the UK rose by 6.2% in the 12 months to January 2024, unchanged for the second consecutive month.

These numbers are too low in comparison to what people have been experiencing. But it is worse than that as this series took quite some time to pick up that anything was happening at all. If you want a technical explanation it is because they use a 14 month stock of rents which means that the number published is not for the month in question as most would understand it as it is lagged. A rough rule of thumb is that it is a year behind reality.

If we look at these numbers over the past three years then the UK has seen a rise of 11.6% according to the official series. At this point those renting must wonder what is being recorded here as they struggle to pay their rent? Regular readers will be aware that I have been challenging these numbers for some years. In fact for a decade because they until recently never got the full rental data. For years the reply was that the Office for National Statistics knew best. At the beginning of December last year that changed although at first they did their best to hide it.

We are improving and transforming our private rental price statistics; these new statistics provide a greater level of granularity in rental price statistics, including local authority estimates, and estimates by property type and number of bedrooms.

In officialese “improving and transforming” means they are confessing they have been wrong. This was followed by an estimate of how much they have been wrong by.

On average, UK annual percentage change reported by the Price Index of Private Rents (PIPR) is 0.7 percentage points higher than the Index of Private Housing Rental Prices (IPHRP) between January 2016 and October 2023.

That may not seem large but they have looked back to 2016 to help cover up what in recent times has been a much larger error as I pointed out on the 1st of December.

 Actually it is presently even worse than that as the difference in October was 2.3%.

So if the error remained the same then the official January estimate for rental inflation would have been 8.5% rather than 6.2%. As rents are 7.7% of the CPI inflation measure then the difference is material.

Rental Equivalence

But there is an elephant in the room because official statisticians around the world have assured us that we can measure owner-occupied housing inflation using rents. That is in spite of the obvious reality that owners do not pay rent. So in the case of the UK the error I have analysed above is multiplied.

The main drivers of the annual inflation rate for CPIH and CPI are the same where they are common to both measures. However, the owner occupiers’ housing costs (OOH) component accounts for 16% of the CPIH and is the main driver for differences between the CPIH and CPI inflation rates. This makes CPIH our most comprehensive measure of inflation.

So the error is multiplied by a 16% weight meaning that the “most comprehensive measure of inflation” has been approximately 0.5% too low in recent times. That is a serious error.

Comment

Those renting are entitled to claim that the official rental inflation numbers have let them down. They have been wrong by a wide amount. Worse than that they have been in denial along the way as the blog post link below shows as they tried to gove the ompression that their way was better.

Measuring rents: stock vs flow

Although there was a sort of Freudian slip.

As a result of the different methods used, it is correct that the IPHRP usually shows lower growth in rental prices than the private sector measures.

Let me now widen my scope to look at international issues. The US CPI has rents as some 34.6% of its index of which 26.8% is pure fantasy based on imputed rents. At just over 6% ( 6.2% for imputed rents) it is pulling the headline number higher so it is particularly material and it is based on a 6 month stock of rents so it is well behind the times. Indeed whilst asking rents are far from an ideal guide it may not even have the direction correct.

US Asking Rents in February were 1% lower than the prior year, the 9th consecutive month w/ a YoY decline. ( @charliebillelo)

So when people say inflation numbers are not correct. It is in fact what should be a simple area ( rents) which shows that they have a point.