May 2016 CPI

Here is an update on inflation.  Core inflation was above trend in January and February, giving hope that we might see a persistent upward trend.  But, since then, inflation outside of rent has fallen back toward the 1% range.

The upward pressure on core CPI inflation is coming from shelter.  Core minus shelter inflation is back below 1.5% and shelter inflation appears to be continuing its climb above 3%.

In 1999 and 2004, when tightening cycles began, at least housing had been healthy and tightening began as shelter inflation was moderating.  This shelter inflation is a supply-side problem, not a monetary issue.  Before 2007 it mostly came from supply constraints in the Closed Access cities.  Since then, it has been exacerbated by the nationwide clampdown on lending.

In both previous cases, I think that the real decline in housing expansion that came from tightening led to rising shelter inflation, which induced the Fed into too much tightening - to disastrous effect in 2007.  In this case, we had a shortage of housing and persistently rising shelter inflation already in place when the Fed started positioning itself for contractionary policies.

Source

I was hoping that core CPI excluding shelter would find some support from natural expansion of the economy and save us from ourselves.  But this recent downturn is what I have been fearing.  If the Fed reads shelter inflation as a monetary issue, then they will add deprivation to deprivation.

Maybe we will be saved by the fact that the PCE price index is the Fed's official guide and it is less sensitive to shelter inflation.

Source

The information I am seeing from mortgage and housing markets is mixed.  There are some signals of mortgage expansion and moderate increases in housing starts, but other signals are stagnant.  Some exogenous shift in housing demand and mortgage expansion might also save us.

The fact that shelter inflation continues to be focused on the rental market, not the owner-occupier market, suggests to me that there will not be an imminent uptick in the recovery in homebuilding.

Just as a reminder, notice how in the supposed housing bubble, inflation for renters was always higher than inflation for owners.  Owner rent inflation didn't tick up until after housing starts collapsed.  The demand for housing wasn't triggered by a rise in owner-occupier demand.  It was triggered by inflation in the Closed Access rental market coming from demand to live in those cities and a lack of housing supply.

This is the opposite of the late 1980s and early 1990s where demand was focused on the suburbs, probably triggered in part by the 1986 tax change that made mortgage debt more valuable and increased marginal demand among owner-occupiers.

I think we can explain the movements from 2006-2009 in steps.  (1) 2006 - the nationwide drop in housing starts coming from contractionary credit and monetary policies cuts off supply of homes, leading to imputed rent inflation across cities, whether open or closed. (2) 2007 - the default crisis leads to a shift of foreclosed households out of homes and back into rentals, reducing owner-occupier demand and putting pressure on rental demand.  (3) after 2007 - this pressure keeps rent inflation for tenants high into 2009, and the lack of mortgage availability for marginal households in the owner-occupier market continues to elevate tenant rent inflation today.