The CPI and housing prices

Nine years ago I did a post discussing how the CPI was distorted by mis-measurement of housing prices:

Good News! There was no housing crash.

At least according to the US government.

The BLS claims that housing prices are up 2.1% in the last 12 months.  Why does this matter?  For all sorts or reasons, but first let’s try to figure out what really happened.  According to the BLS, housing makes up nearly 40% of the core basket of goods and services.

Category    weight     inflation

Housing     39 %             2.1%

Other         61%              1.4%

Overall      100%             1.7%

Suppose that instead of rising 2.1%, housing costs have actually fallen 2.1% over the past 12 months?  In that case the core rate would be zero.  Which number seems more likely?  For much of the past year house prices have been falling at more than 2% a month.

Bloomberg reports a new academic study that reached similar conclusions:

New research shows that the CPI is slow to reflect changes in prices—and, equally important, understates the degree to which prices move up and down. The problem stems from the way the government calculates the price of shelter, a category that makes up one-third of the index.

Three economists have developed an alternative measure that captures price moves as soon as they occur and shows the full range of changes. If it had existed in 2008-09, when the economy was in the deepest recession since the Great Depression, it would have shown far deeper deflation than the Bureau of Labor Statistics registered. The official CPI, they write in a new paper, was overstating inflation by 1.7 percentage points to 4.2 percentage points annually during the Great Recession. More recently, they write, the problem has been the opposite: Annual readings have understated inflation by 0.3 to 0.9 percentage points. Those are huge disparities given that forecasters make a big deal of fluctuations of just one or two tenths of a percentage point in the official rate.

Here’s a graph that shows how big a difference it makes:

Screen Shot 2018-05-10 at 8.33.59 PM

That correction is actually a bit larger than even I would have expected.  But even if their method is not perfect, I have little doubt that the basic point is correct; the CPI is less volatile than an alternative price index that reflects actual market prices in the economy.

The problem they point to is similar to the one I mentioned back in 2009. The BLS uses rent payments on existing contracts that do not reflect the market rent on apartments currently on the market.  During a slump, it’s not unusual for a new tenant to get one or two months free rent:

The economists behind it are Brent Ambrose and Jiro Yoshida of Pennsylvania State University’s Smeal College of Business and Edward Coulson of the Merage School of Business at the University of California at Irvine. Their latest version is described in an April 20 academic paper titled “Housing Rents and Inflation Rates.” The key difference from the CPI is that their measure factors in only new rental leases, including those of new tenants and old ones who recently renewed. The BLS, in contrast, also includes rent paid by tenants whose leases weren’t up for renewal in the latest month, which means it’s slower to pick up on changes in market conditions.

Kudos to Ambrose, Yoshida and Coulson for putting a spotlight on a very important flaw in the CPI, which many professional economists use too uncritically.

Send in the clowns

Italy’s Five Star Movement was founded by a clown.  Now they have been elected to govern all of Italy.  Here are some of their views:

An alliance between Five Star and the League has long been considered the most destabilising outcome to the eurozone of the election because both parties have attacked EU fiscal rules, banking regulations, trade deals and sanctions against Russia.

Notice that there’s no real ideology there, other than always taking the “irresponsible” position, no matter what the issue.  It would be like if America were to elect a buffoon who had no discernible ideology other than being irresponsible.  Someone who opposed responsible conservative policies like slowing the growth in entitlements and a smaller deficit, but also opposed responsible progressive policies like the Paris Accord or the Iran deal.  And also opposed responsible centrist polices, such as speaking out against Putin and enacting trade agreements like TPP. Someone who’s only ideology was to be irresponsible. Thank God we are not Italy.

Meanwhile, The Economist had an interesting piece on Germany:

A cultural divide is opening up between urban regions and more conservative suburban and rural areas. “Cities like Munich, Cologne and Berlin now have more in common with each other than with their own hinterlands,” says Michael Bröning, author of a new book on nationhood. And rising crime rates and cultural battles like the one in Essen are making society feel more raw. On New Year’s Eve 2015 in Cologne some 1,000 women were sexually assaulted by a crowd made up largely of immigrants. A year later an Islamist terrorist from Tunisia drove a hijacked truck into a Christmas market in Berlin, killing 12. The titles of recent books and films—“Nervous Republic”, “Fear for Germany”, “The End of Germany”—capture the public mood at its gloomiest.

This raises a host of issues.  First of all, notice the similarity to America, where Dallas, Houston and Atlanta vote Democratic and the surrounding areas are quite conservative.  Also notice that the anti-immigrant feeling is strongest in the areas that have the fewest immigrants.  Recall the massive support for Trump in West Virginia, which attracts almost no immigrants and benefits from trade with China.  And notice that Germany has a booming manufacturing sector and a trade surplus, so the economic factors that supposedly drove support for Trump (which I doubt actually did) are not in play in Germany.  I suspect that the increase in nationalism in Germany is occurring for the same reason as in Russia, India, Turkey, China, Hungary and dozens of other countries, and has almost nothing to do with the factors that we are told are pushing America toward right-wing populist authoritarianism.  I have no idea what those factors are, indeed I’ve never even seen a plausible theory.  BTW, if you want a better insight into the Trump phenomenon, then read this excellent article on the Modi phenomenon in India.  The parallels are eerie. The bad news is that if I’m right, Trump is likely to be re-elected.  (But my track record on political predictions is—spotty.)

PS.  George Will takes the gloves off in the Washington Post, making a good case that Pence is even worse than Trump (a view I would have thought ridiculous a few months ago.)

And people think I have TDS!

PPS.  At the other extreme from George Will is Conrad Black, who suggests that Trump was an honest businessman, and who describes his marriage to Melania as being free of stormy weather:

The relationship has apparently lasted smoothly for nearly 20 years

This piece somehow made it into the National Review.  Do magazines still have editors?

Where the FTPL applies

The fiscal theory of the price level does not explain very much in the US.  Inflation often soars much higher during periods when the national debt is low and falling (the 1960s) and falls sharply when the deficit increases dramatically (the 1980s).  But the FTPL does explain the inflation dynamics of Argentina:

“The [peso] price action looks like a loss of confidence by foreign investors coupled with some form of “capitulation” by domestic investors,” he added. “Markets need to see a radical tightening in fiscal policy in order to stabilise the situation, and that includes cutting wage hikes in order to fight inflation.

There is also some data that sounds suspiciously NeoFisherian:

Argentina’s peso is again feeling the heat.

The currency has fallen to a new record low of 23 against the dollar after slumping 5 per cent in morning trade on Tuesday. . . .

The declines come despite massive intervention by the Argentine central bank, which hiked interest rates by an unprecedented 12.75 percentage points to 40 per cent in the space of just seven days last week.

As always, however, you need to keep in mind the correlation/causation distinction.  Most likely it’s the high inflation causing the high nominal interest rates, not vice versa.  (Or if you prefer, the budget deficits are causing both.)

Was NeoFisherism vindicated?

Rajat directed me to a new post by Stephen Williamson, which suggests that recent events provide support for the NeoFisherian view.  The Fed has been gradually raising their interest rate target since late 2015, and inflation has gradually risen from near zero up to roughly 2%.  In addition, nominal interest rates are positively correlated with inflation rates at the international level.

Here are three ways of interpreting that evidence:

1. Higher interest rates cause higher inflation.  (NeoFisherism)

2. Low unemployment led the Fed to fear inflation (Phillips Curve), and they tightened monetary policy to prevent inflation from overshooting. (Keynesian)

3. The Fed did not tighten at all.  Contra NeoFisherism, raising the interest rate target is usually contractionary, ceteris paribus.  But the Fed often raises rates during periods when the natural rate is rising, and in most cases they raise rates more slowly that the natural rate is rising.  This means that while it is true that raising rates is usually contractionary, ceteris paribus, in the majority of cases a period of rising interest rates is also a period of increasingly expansionary monetary policy. I would argue that 2017 was no different. So I also reject the Keynesian view.

I prefer the second and third explanation to the first because the NeoFisherian view is inconsistent with the response of asset prices to unexpected changes in the central bank’s nominal interest rate target.  And I prefer the third explanation to the second because the Phillips Curve is not a reliable way of forecasting inflation, and changes in the nominal interest rate are not a reliable indicator of changes in the stance of monetary policy.

Off topic, I just returned from a monetary conference at the Hoover Institution, which was attended by no fewer than 4 Fed presidents.  I was delighted to see both John Williams (who was recently appointed to the New York Fed), and Robert Kaplan (Dallas Fed) mention both price level and NGDP level targeting as promising options to think about.  While neither endorsed these policy options, I had the impression that if the Fed were not already committed to inflation targeting, these two Fed presidents would probably be favorably inclined to one of these two approaches.  Kaplan seemed especially interested in NGDP targeting.  However, I don’t expect the Fed to change its policy target as long as things are going well.  Instead, I’d expect some consideration of level targeting the next time we go into a recession, and hit the zero bound.


Beckworth interviews Hamilton

David Beckworth recently interviewed Jim Hamilton on a wide variety of topics, including energy and monetary policy.  At one point they discussed Hamilton’s recent research on the impact of QE.  Hamilton discussed the March 18, 2009 QE announcement, which is sometimes cited as evidence that QE was effective.  On the day of the announcement, 10-year bond yields plunged from roughly 3.0% to 2.5%.

Hamilton pointed out that the market response doesn’t necessarily indicate that rates fell due to monetary expansion.  An alternative interpretation is that the announcement led traders to re-evaluate their view of the economy, perceiving the Fed to have relevant non-public information. Hamilton suggested that investors may have thought:

What do they know that I didn’t?  And, maybe the economy is in worse shape than I thought.

If that were the case, then you’d expect other markets to reflect this bearish perception.  In fact, exactly the opposite occurred.  Here is the NYT, from March 18, 2009:

The Federal Reserve sharply stepped up its efforts to bolster the economy on Wednesday, announcing that it would pump an extra $1 trillion into the financial system by purchasing Treasury bonds and mortgage securities. . . .

Investors responded with surprise and enthusiasm. The Dow Jones industrial average, which had been down about 50 points just before the announcement, jumped immediately and ended the day up almost 91 points at 7,486.58. Yields on long-term Treasury bonds dropped markedly, and analysts predicted that interest rates on fixed-rate mortgages would soon drop below 5 percent.

This suggests that markets treated the QE announcement as an expansionary monetary policy, which sharply lowered long term bond yields and also raised equity prices by roughly 2%.

On the other hand, I do agree with Hamilton’s claim that the big decline in interest rates (throughout the world) during the Great Recession was mostly due to other factors such as slow growth, not QE.

PS.  Let me reiterate that QE is not a policy, it’s a tool.  Thus QE is not the way to prevent demand shortfalls.  To do that you need a sound monetary policy, preferably NGDPLT.  Then QE can be used as a tool to implement that policy, in the unlikely event it is needed.