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Wednesday, July 26, 2006

The Fed's "Greatest Single Worry"

New Economist and Brad Setser kindly call Tim Duy, who (luckily for me) does Fed Watch here, the "John Berry of the blogosphere." I think that's a nice endorsement of John Berry's work:

Fed Is Showing Concern Over Housing Retrenchment, by John M. Berry, Bloomberg: Nothing has been more important in driving the U.S. economic expansion that began nearly five years ago than housing. It could be just as vital as growth slows.

Federal Reserve officials are watching warily to see whether the housing retrenchment that began late last year will remain modest or turn into a rout that could damage the economy severely.

The Fed raised interest rates 17 consecutive times over the past two years to keep inflation under control, and the officials have understood that at some point that would sting housing.

What has only become evident in recent months is that, perversely, the big decline in housing affordability -- due to the combination of double-digit housing price increases year after year and higher mortgage-interest rates -- would cause a surge in core inflation.

Would-be homeowners -- either priced out of the market or simply fearful that the value of a home purchased now could fall in coming months -- are renting instead. As a result, rents of residences and the so-called owners' equivalent rent components of the consumer price index have shot up this year.

Together, those carry such large weights in the CPI that their increases accounted for almost two-thirds of the full percentage point increase in the core CPI in the first half of this year. From December to June, the core rose at a 3.2 percent annual rate, up from a 2.2 percent rate in the second half of last year.

The National Association of Homebuilders, never a fan of Fed-engineered interest rate increases, complained about this ... in a letter to Senator Paul Sarbanes, the ranking Democrat on the Senate Banking Committee, prior to Fed Chairman Ben S. Bernanke's appearance before the committee on July 19. ... Sarbanes, in questioning Benanke, asked whether the decline in housing might go too far. And of the NAHB argument about rents, he observed, ''That seems to me to have some validity.''

''On your first point about housing, we are watching the housing market very carefully,'' the Fed chairman responded. ''Other parts of the economy are picking up to offset some of the weakness we see in the housing market. But we are watching that very carefully.''

As for the links among rising interest rates, a cooling housing market, increasing rents and the surge in core CPI, Bernanke said that the high weight rents carry in that index is one reason the Fed prefers to focus on the core personal consumption expenditure price index. The PCE index, he said, ''puts a much lower weight'' on rents, he said.

In addition, Bernanke said, ''the increase in inflation we have seen is a much broader phenomenon than that single component. If that single component was the only issue, I would think twice.''

Presumably, the Fed chairman meant that he would think twice about raising the Fed's target for the overnight lending rate if rents were the only issue.

Even if rents aren't the only issue, the causes of why they are rising so much mean that Fed officials do regard them somewhat separately from the other inflationary pressures at work. Essentially, the surge in rents is seen as a transitory phenomenon that will ease gradually. ...

The Commerce Department reported yesterday that sales of existing homes dropped 1.3 percent in June, to a 6.62 million unit annual rate. That's almost 9 percent below the sales rate in June 2005.

The number of unsold homes on the market rose to 3.725 million units, almost 40 percent more than a year earlier. ''This implies that we are only at an early stage of home sale problems,'' economist Ken Mayland of ClearView Economics told his clients. ''At some point along the way, prices could crack big time.''

Fed officials recognize that possibility. It is probably their greatest single worry about growth right now.

David Altig has more on the influence of rent and owner's equivalent rent on inflation measures.

    Posted by on Wednesday, July 26, 2006 at 12:12 AM in Economics, Housing, Monetary Policy | Permalink  TrackBack (0)  Comments (13)


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