Does the Fed have an inflation blind spot with grocery and housing prices?
"There are economic models, and there is real life.
Over the past week alone, the price of corn rose 8% to the highest level since 2013, while soybeans and wheat prices hit their highest points since 2014. The CRB foodstuff index, which includes hogs, butter, and sugar, in addition to grains and other agricultural commodities, is up 15% this year and trading at the highest level since summer 2012. Grocery prices are in turn at seven-year highs. Meanwhile, the price of an existing home surged 17% in March from a year ago—the fastest pace on record.
The official inflation numbers favored by policy makers, and thus the focus of traders and investors, don’t exactly capture those stark price increases. The Federal Reserve and many economists emphasize core inflation, or indexes that exclude food (and energy) prices, because those components can be volatile. As for housing, government economists consider homes an asset, not a good or service that is consumed, and so home prices don’t directly figure into carefully watched inflation gauges.
Ignoring such price changes when they are moving persistently and significantly leaves a major blind spot, setting up a disconnect between what official stats say and what people and businesses feel. Consider that food and housing together represent 27% and 33% of household income and spending, respectively, Labor Department data show. The problem worth contemplating is that those real-world prices shape the inflation expectations that wind up determining actual inflation. Here, perception becomes reality.
Francesco D’Acunto, a professor at Boston College, has found that inflation expectations are shaped by the price changes consumers face specifically while grocery shopping. Grocery price inflation is at this point running about 3%, meaning consumers believe inflation is running about double the reported core consumer-price-index rate, he says. The average person probably doesn’t consider supply-chain issues that have helped push the price of pork chops 9% higher, and D’Acunto’s research shows it takes six to 12 months before inflation expectations change dramatically. Given food increases to date, that point is two to three months out, he says.
“What matters is what households think,” says D’Acunto. Excluding the very items to which consumers are most exposed means policy makers may “find themselves basing policy on assumptions that are totally off,” he says.
Whereas food prices are simply stripped from core inflation metrics, housing’s treatment is trickier. It’s shelter people consume, the logic goes, and so government economists use what’s known as owners’ equivalent rent—how much a homeowners say they would have to pay in rent—to calculate inflation gauges’ monthly housing component.
No method is perfect and any one method will have its detractors. Even setting aside methodology complaints, though, there are red flags in the shelter numbers we do have.
Citigroup economist Veronica Clark says the most important element of March’s hot CPI report was another solid increase in owners’ equivalent rent, or OER, that has come about five months before she anticipated. Housing prices tend to lead rents, Clark says, meaning that while double-digit home price gains don’t directly show up in the CPI or the personal consumption expenditure index, or PCE, they do pull up the price of shelter with a lag time of about one year. Given that home prices started to balloon at the beginning of the pandemic, “we’re getting to that period where we should start to see upward pull show up for rents,” says Clark.
What makes the OER signal worth heeding is the idea that shelter is indicative of the underlying pace of inflation. Shelter prices aren’t volatile and a couple months of creep usually portend a longer stretch of increases, Clark says. “Shelter really wouldn’t be considered transitory,” she says, as it is more driven by economic fundamentals.
While it may seem odd to watch home prices explode month after month as the official shelter component runs below 2%, what makes housing’s treatment more contentious is how heavily shelter is weighted in inflation baskets. The largest component by far, shelter comprises 40% of the core CPI. That begs criticism that, at least during this housing boom, housing’s treatment introduces a downward bias to the CPI that is the basis for adjusting everything from Social Security payments to tax brackets, let alone interest rates.
A report during the week from Realtor.com, which showed rent prices in March rose for the first time since last summer, suggests higher home prices may already be affecting rents. All of this isn’t to mention the potential impact on inflation expectations; you don’t need to be an active buyer or seller to notice soaring home prices.
Looking beyond current red flags, there are plenty of reasons to believe inflation will strengthen over the next few years, including massive fiscal stimulus, pent-up demand, and limited labor supply, says David Kelly, chief global strategist at JPMorgan Funds. Because such an environment poses a threat to both bonds and stocks while also eroding the inflation-adjusted value of cash, Kelly says investors should consider some extra exposure to commodities through funds that invest broadly across the commodity sector. While commodities tend to match inflation over the longer term, he says, they outperform during periods of high inflation. So too does real estate.”