Wednesday, September 17, 2014

Inflation, Housing, QE, and the Taper in August

Inflation in August still leaves open the possibility that the Fed has tapered QE3 too soon, making the same mistake they made with QE2.

The recent crisis was marked by a demand crisis that was felt most harshly in real estate credit markets.  So, core inflation (less shelter) is mostly a reflection of demand.  But, since real estate has been limited by the crisis in real estate credit markets, shelter inflation is a reflection of a supply shock.  Further economic recovery will be difficult without further recovery in real estate credit.

If the recovery continues to be healthy, we should see rising Core (minus shelter) inflation due to increased demand and falling Shelter inflation due to increases in home supply as home prices continue to recover and new housing starts increase.  Unfortunately, now we are seeing the opposite.

Here are graphs of Month over Month inflation and Year over Year inflation - Core, Shelter, and Core minus Shelter.  What we are seeing now is continued strength in Shelter inflation, reflecting the shortage of housing while strengthening demand bumps up against real estate credit and new home building that are only very slowly recovering.

Core minus Shelter inflation was strong in late spring, but has now fallen for four consecutive months, including two months of core deflation.

These are noisy series, so there is still hope, but this does leave the possibility open that the taper came too soon and there isn't enough escape velocity in credit markets to push home values high enough to return us to self-sustaining recovery.

Real estate credit doesn't offer any clues.  After five years of decline and stagnation, real estate credit finally started recovering this year.  Real estate credit held at commercial banks has been growing at a rate of about 5% all year.  But, a healthy credit market would be growing by at least 10%.  And, household mortgages, tracked by the Federal Reserve, show even less promising recovery.

I think we need to have home leverage back to normal levels and a natural interest rate above zero in order to escape, and these things will happen together or not at all.  Both are marginally there now.  The recovery is happening in many facets - employment, foreclosures and loan-to-value, commercial and industrial credit, consumer credit, consumer confidence, service and manufacturing indicators, etc.  There are an awful lot of things pushing us in the right direction.  But, this inflation report leaves open the possibility of a slowdown before we get there.

Looking ahead, if the Fed is targeting inflation, we might be looking at a sort of tipping point.  If continued real estate credit recovery leads to new home building and a decline in shelter inflation, the Fed might be lulled into getting too far behind rising demand.  But, if real estate credit stagnates, and a supply shock in shelter causes inflation to surge, the Fed might miss the underlying deflationary trend.  Politically, it would be very difficult for the Fed to open up another round of liquidity injections.  This outcome could be disastrous.

I'm still positioned for the expansionary outcome.  But it bears watching.


  1. Excellent blogging. There is a long history and controversy over housing costs and the measurement of inflation. So...why obsess about inflation and not real growth?

  2. TravisV here.

    Parts of this analysis just don't feel right........

    Scott Grannis: "The return of King Dollar"

    1. I find it difficult to parse currency fluctuations. It sounds like Grannis has some of the concerns I do about tightening too soon. Am I reading that right? Where do you stand?

  3. TravisV here.