Yesterday’s CPI report confirmed what most people think – inflation is running much cooler than most presume. This isn’t shocking when we consider the high unemployment rate, the low capacity utilization, the substantial output gap and the generally sluggish conditions. Producers just don’t have a huge amount of pricing power given the weakness of aggregate demand. But inflation isn’t always an even phenomenon and asset price inflation has become an increasingly dangerous phenomenon in recent years.
Of course, this has been nowhere more apparent than it is in the real estate market where soaring prices only just recently led to a near collapse in the US economy. And while I became fairly bullish on housing last year I have to admit that the level of the rally in real estate has been very surprising. Prices are up 12.2% year over year according to CoreLogic.
Of course, this is a tricky way to view inflation because the BLS doesn’t count housing prices as consumption, but investment. I don’t think the investment/consumption view of real estate is quite so black and white which is why I embed real estate prices in the Orcam Housing Adjust Price Index. The latest reading on the OHAPI is showing 4% year over year inflation. That’s more than double what the CPI is saying.
Now, this might not accurately reflect a price basket as well as the CPI does, but inflation is always and everywhere an uneven phenomenon and asset price inflation in the consumer’s most important balance sheet item is worth keeping an eye on. Had we tracked something like the OHAPI in the early 2000’s we would have never fallen for the idea that inflation was low during the biggest housing boom in US history. Had the Fed been viewing price changes through a gauge like this they might have been faster to tighten policy and get ahead of what was clearly a dangerous trend.
Are we getting into a dangerous environment like we saw in 2007? I certainly don’t think so quite yet, but Fed policy should be proactive and not reactive. To me, the path forward appears obvious. I think QE is having more destabilizing than stabilizing effects here and the Fed could probably do a great deal to cool real estate trends before they potentially get out of hand again by simply ending the QE program. The portfolio rebalancing effect via QE is creating excessive demand in other financial assets that could cause economic instability in parts of the economy that exacerbate risks. The Fed should maintain ZIRP, but eliminate what is perceived as an asset inflationary policy. I don’t think inflation is at risk of running out of control here, but the uneven price action in some markets is something we should be aware of before it’s too late.
(Orcam Housing Adjusted Price Index via Orcam Research)