The Fed targets inflation as measured by the change in the personal consumption expenditures (PCE) deflator, which tracks the prices of a representative mix of goods and services purchased by the typical American. By this measure, inflation peaked at well over 7 percent two years ago, and although it has fallen below 3 percent today, it still remains well above it. the Fed's 2% target. The widely followed consumer price index shows a similar trend.
However, these are flawed measures of inflation, based largely on an ill-conceived notion of the cost of homeownership. Both attempt to capture the cost of homeownership by estimating the rent a homeowner would pay for a similar home nearby. This is problematic for two main reasons.
First, using this rent-equivalent approach results in miscalculation of the true cost of owning a home when renting and owning costs diverge, as they do in today's market. The vast majority of U.S. homeowners are mortgage-free or have the same fixed-rate mortgage as last year, and are paying similar housing costs. However, their implicit rent increased with that of the real tenants.
The rental equivalence approach breaks down even further when the owner-occupied stock is different from the rental property stock. It is virtually impossible, for example, to provide a useful measure of implicit rent for landlords in communities where most housing units are owner-occupied, or where the rental stock is almost entirely multifamily and the owner-occupied stock almost entirely exclusively single-family. There simply isn't enough inventory to determine comparable rents, especially during a nationwide housing shortage.
Because of these and other difficulties in measuring the cost of homeownership, most developed countries treat owner-occupied housing as an investment and exclude it from their inflation estimates. Yet in the United States, it is given more weight than any other good or service considered in the two preferred measures of inflation. If the Fed followed the wise example of the rest of the developed world and removed this variable from its measures, it would find that inflation is right on target of 2%. In fact, he's been there since last fall.
But more important than misjudging the cost of owning a home is that the Fed is basing its current hike-and-longer strategy on a misunderstanding of what really explains the high cost of housing. accession to property. While rising interest rates weigh on the prices of most goods and services by reducing demand, their impact on the cost of homeownership is more complicated.
The primary cause of the extremely high cost of owning a home is a long-standing shortfall in supply. For years, the supply of homes to rent or buy has fallen far below demand in much of the country, driving rents and home prices to historic highs. The situation has been exacerbated by the covid-19 pandemic, which has severely disrupted supply chains and the workforce needed to build more housing.
High interest rates have made the situation even worse by making it harder and more expensive for builders and developers to finance new construction. Coupled with the still-high costs of land, labor and materials, they have made building new homes simply too expensive in many parts of the country. Additionally, rising interest rates are making many homeowners understandably reluctant to give up their much lower mortgage rate and put their home on the market.
This disruption in the supply of housing raises the cost of buying and renting, driving up the very measure of inflation on which the Fed relies. The tool the Fed uses to lower inflation does the exact opposite.
This puts the Fed in a sort of box. He has repeatedly stated that he aims for 2 percent inflation, as measured by the PCE deflator. If he changes course now, investors could conclude that he is moving his target, calling into question his commitment to low and stable inflation. But if the Fed explains why it focuses on the more reliable measure of inflation used by most other developed countries, the credibility problem should be short-lived. The alternative of sticking with the wrong measurement is indeed likely to do more damage to one's reputation in the long term. The Fed would therefore be doing itself a favor by starting to adopt a more precise measure.
The economy has weathered the Fed's long-term hike strategy admirably, but there is a growing threat that continued pressure will expose flaws in the financial system. As last year's banking crisis showed, the relentless pressure of high interest rates can cause parts of the financial system to distort in ways that are difficult to predict and control.
The job market also appears increasingly fragile as companies have cut back on hiring, reduced working hours and used fewer temporary workers. They have been reluctant to lay off workers, but that could quickly buckle under the mounting weight of high interest rates.
There is no reason to take these risks just to achieve the wrong inflation target. It would be better if the Fed recognized its hard-won victory against inflation and finally started cutting interest rates.