Shelter Inflation

Monday 03/24/14

Last week the markets moved higher, but ended the week on a down note. The Fed announced that they would reduce their open market purchases of treasuries and mortgage backed securities by another $10 billion. While the $10 billion dollar reduction was widely expected, the market was caught off-guard by a comment made by Janet Yellen in the press conference following the announcement. The official fed statement stated that, “The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.” Normally this sentence wouldn’t be very controversial, but in a press conference following this statement, Janet Yellen was asked how long a considerable period of time was by Ann Saphir from Reuters. Yellen responded somewhat hesitantly, but then said that it would be, “…something on the order of six months or that type of thing.” The market was not happy to hear this. Yields on treasuries began rising and stocks fell, eventually closing near the lows of the day. The next day the market’s calmed down, writing her statement off as a rookie mistake. However, St. Louis fed President James Bullard suggested that six months was in-line with private sector expectations and that Yellen was just repeating that.

Ending the asset purchase program is one thing, but raising interest rates is another story. Many portfolio managers have viewed rising interest rates as something that will happen eventually, but not any time soon. The effects of quantitative easing have always been murky, but the effects of raising interest rates are much clearer. Raising interest rates is typically used when the fed wants to put the brakes on the economy, because they are concerned about inflation. The U.S. has experienced inflation levels well below the fed’s target for quite some time, so why would the fed even be discussing raising interest rates?

I suspect that the fed will not raise interest rates in 2015. Unemployment is still very high, but inflation has been subdued for an extended period of time. While the current level inflation is low, the fed is more concerned with long run inflation. As I have mentioned often in the past, the Cleveland fed uses a variety of techniques to determine long run inflation expectations. The latest estimate of 10-year inflation expectations from the Cleveland fed was 1.77% which means that expectations are less than the long term goals of the fed.

In a recent report , the Cleveland fed noticed an interesting set of data that was bucking the disinflation trend. In this report, they noticed that “A bigger driver of the trend in shelter inflation has been a run-up coming from owners’ equivalent rent of residences (OER).” Owner’s equivalent rent is determined by the Bureau of Labor Statistics by asking the following question, “If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?" The Cleveland Fed also cuts out OER from existing inflation calculations and shows that overall median CPI would have fallen substantially since 2012 if this were the case. As I showed in last week’s newsletter home prices suddenly began rising quickly in 2012. Interestingly this coincides with the founding of Blackstone’s Invitation Homes unit. I also pointed out that the initial push from private equity buyers is coming to an end. Coincidentally OER has fallen in recent months as the private equity buying spree came to an end. This means that the biggest driver of inflationary pressures over the last few years is going away and I suspect that inflation will remain well below the levels that the fed is comfortable and may even go lower which will prevent them from raising interest rates.