By Jon Hilsenrath
The Federal Reserve predicates its easy money policies in part on the fact that its favorite measure of inflation has run more than a half percentage point below its goal for several years.
With inflation so low for so long, the thinking goes, the Fed can hold interest rates very low for a while to help boost the economy as it recovers from the effects of the coronavirus pandemic.
This raises an important question: Is the central bank thinking about inflation properly?
The Fed defines its inflation target in terms of consumer prices, such as those we pay for cars, toothpaste and haircuts. But in recent decades, prices have often climbed much faster for investment assets, such as homes and stocks, and twice led to booms and busts followed by recessions.
If the Fed does run into problems with the low interest rates it has helped to engineer, it might be because of asset prices and not consumer prices.
The Fed’s inflation target comes from a 1977 congressional mandate requiring the central bank to achieve “stable prices,” in addition to maximum employment and moderate long-term interest rates. Because of high consumer-price inflation in the 1970s, the price stability mandate for many years got most of the central bank’s attention, and the Fed drove inflation down.
It wasn’t until 2012 that the Fed adopted a numerical definition of its goal. It said it sought 2% inflation as measured by the Commerce Department’s personal-consumption expenditures price index over the medium run. In other words, its measure was the cost of household goods and services.
Since 2012, this measure has averaged 1.3% annual growth — a long time below the Fed’s goal. Critics who warned the Fed’s easy money policies of the 2010s would lead to an inflation surge, a financial bubble and a collapsing dollar turned out to be flat out wrong. All the more reason to keep interest rates exceptionally low today, when the economy is struggling, the Fed’s thinking goes.
Low rates are intended to spur borrowing, spending and investment, supporting economic growth and hiring.
As society has become more affluent, more resources have gone into assets like stocks, bonds and second homes. Perhaps not coincidentally, two of the last three U.S. recessions were driven by asset price bubbles — a tech stock boom in the late 1990s and a housing price boom in the 2000s — that caused economic imbalances even though consumer prices made barely a peep.
Cheap imports from abroad, among other global forces, might be holding down U.S. consumer prices while asset prices march higher, creating new risks that could sideline the economy in unexpected ways.
It is easy to find reasons for discomfort. Tesla’s stock price is up more than 300% in the past year. Copper prices are up 56%. The S&P Case-Shiller Home price index is up 9.5%. Freight prices are up 215%; soybeans, 54%, lumber, 117%.
Homes are particularly thorny. They provide a service — we live in them — that is measured in official consumer-price indexes. They are also the most valuable asset in the investment portfolios of many households. The investment part isn’t measured in these inflation indexes. Rather than track actual home prices, the indexes estimate housing costs based on the rents paid in big cities.
With Covid-19 decimating commerce in cities and people leaving, no wonder the Labor Department’s official measure of rental housing costs in the past year rose just 2%, while home prices nationally were up at nearly five times that rate. In 2004 and 2005, as a housing bubble grew, the Labor Department measure of rents averaged gains of little more than 2% annually.
“You have faulty price measurements and policy makers linking their decisions to faulty price measurements,” says Joseph Carson, a former Alliance Bernstein and Commerce Department economist.
While stable consumer prices are the primary focus of monetary policy, asset prices are the domain of regulators.
The Fed and Treasury Department are counting on monitoring systems they have set up since the 2007-2009 financial crisis to spot problems in asset prices — such as booms driven by investor borrowing binges — that might destabilize the financial system. It is then for regulators to figure out what to do.
“Monetary policy should not be the first line of defense,” against destabilizing asset price booms, Fed Chairman Jerome Powell said at a press conference last September. Raising rates to tame asset bubbles, he said, could be a secondary reaction.
One of the lessons of the past two asset price booms was that it was hard to identify the bubble while it was inflating and even harder to stop it without creating collateral economic damage.
For now, markets and the people monitoring them don’t seem very concerned.
In answer to a question at his January press conference, Mr. Powell said he saw rising home prices as a temporary reaction to the Covid-19 crisis, with people switching residences to adapt.
Nancy Davis, founder of Quadratic Capital, a $1.5 billion investment management fund, notes that in swaps markets, where companies hedge inflation and interest-rate risk, firms are pricing inflation in the two-to-10 year horizon at about 1% a year, even further below the Fed’s target.
The market might be complacent, she said. Or it might be saying that the risk of a pickup in inflation is no more serious than the risk of falling consumer prices, known as deflation.
“Nobody knows what’s going to happen,” she said, “especially the economists.”
Write to Jon Hilsenrath at [email protected]
(END) Dow Jones Newswires