You Say You're a Homeowner and Not a Renter? Think Again.

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March 11, 2013

You Say You're a Homeowner and Not a Renter? Think Again.

As we've said before, we're suckers for cool charts. The latest that caught our eye is the following one, originally created by the U.S. Bureau of Labor Statistics (BLS). It highlights the relative importance assigned to the various components of the consumer price index (CPI) and shows where increases in the index have come from over the past 12 months.

It probably won't surprise anyone that the drop in gasoline prices (found in the transportation component) exerted downward pressure on the CPI last year, while the cost of medical care pushed the price index higher. What might surprise you is the size of that big, blue square labeled 'housing.' Housing accounts for a little more than 40 percent of the CPI market basket and, given its weight, any change in this component significantly affects the overall index.

This begs the question: In light of the recent strength seen in the housing market'and notably the nearly 10 percent rise in home prices over the past 12 months'are housing costs likely to exert more upward pressure on the CPI?

Before we dive into this question, it's important to understand that home prices do not directly enter into the computation of the CPI (or the personal consumption expenditures [PCE] price index, for that matter). This is because a home is an asset, and an increase in its value does not impose a 'cost' on the homeowner. But there is a cost that homeowners face in addition to home maintenance and utilities, and that's the implied rent they incur by living in their home rather than renting it out. In effect, every homeowner is his or her own tenant, and the rent they forgo each month is called the 'owners' equivalent rent' (or OER) in the CPI. OER represents about 24 percent of the CPI (and about 11 percent of the PCE price index). The CPI captures this OER cost (sensibly, in our view) by measuring the cost of home rentals (details here). So whether the robust rise in home prices will influence the behavior of the CPI this year depends on whether rising home prices influence home rents.

So what is likely to happen to OER given the continued increase in home prices? Well, higher home prices, in time, ought to cause home rents to rise, putting upward pressure on the CPI. Homes are assets to landlords, after all, and landlords (like all investors) require an adequate return on their investments. Let's call this the 'asset market influence' of home prices on home rents. But the rents that landlords charge also compete with homeownership. If renters decide to become homeowners, the rental market loses customers, which should push home rents in the opposite direction of home prices for a time. Let's call this the 'substitution influence' on rent prices.

Consider the following charts, which show three-month home prices and home rents (measured by the CPI's OER measure). It's a little hard to see a clear correlation between these two measures.

So we've separated these data into their trend and cycle components (using Hodrick-Prescott procedures, if you must know) shown in the following two charts. Now, if one takes the trend view, there is a clear positive relationship between home prices and home rents. This is consistent with the asset market influence described above. But also consider the detrended perspective. Here, home prices and home rents are pretty clearly negatively correlated. This, to us, looks like the substitution influence described above.

So let's get back to the question at hand. What do rising home prices mean for OER and, ultimately, the behavior of the CPI? Well, it's rather hard to say because the link between home prices and OER isn't particularly strong.

Not definitive enough for you? OK, how about this: We think the recent rise in home prices will more likely lean against the rise in OER for the near term as the growing demand for home ownership provides some competition to the rental market. But, in time, these influences will give way to the asset market fundamentals, and rents are likely to accelerate as returns on real estate investments are reaffirmed.

By Mike Bryan, vice president and senior economist, and

Nick Parker, economic research analyst, both in the Atlanta Fed's research department

March 11, 2013 in Economics, Housing, Real Estate | Permalink

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Will the Next Exit from Monetary Stimulus Really Be Different from the Last?

« What the Dual Mandate Looks Like | Main

March 08, 2013

Will the Next Exit from Monetary Stimulus Really Be Different from the Last?

Suppose you run a manufacturing business'let's say, for example, widgets. Your customers are loyal and steady, but you are never completely certain when they are going to show up asking you to satisfy their widget desires.

Given this uncertainty, you consider two different strategies to meet the needs of your customers. One option is to produce a large quantity of widgets at once, store the product in your warehouse, and when a customer calls, pull the widgets out of inventory as required.

A second option is to simply wait until buyers arrive at your door and produce widgets on demand, which you can do instantaneously and in as large a quantity as you like.

Thinking only about whether you can meet customer demand when it presents itself, these two options are basically identical. In the first case you have a large inventory to support your sales. In the second case you have a large'in fact, infinitely large'"shadow" inventory that you can bring into existence in lockstep with demand.

I invite you to think about this example as you contemplate this familiar graph of the Federal Reserve's balance sheet:

I gather that a good measure of concern about the size of the Fed's (still growing) balance sheet comes from the notion that there is more inherent inflation risk with bank reserves that exceed $1.5 trillion than there would be with reserves somewhere in the neighborhood of $10 billion (which would be the ballpark value for the pre-crisis level of reserves).

I understand this concern, but I don't believe that it is entirely warranted. My argument is as follows: The policy strategy for tightening policy (or exiting stimulus) when the banking system is flush with reserves is equivalent to the strategy when the banking system has low (or even zero) reserves in the same way that the two strategies for meeting customer demand that I offered at the outset of this post are equivalent.

Here's why. Suppose, just for example, that bank reserves are literally zero and the Federal Open Market Committee (FOMC) has set a federal funds rate target of, say, 3 percent. Despite the fact that bank reserves are zero there is a real sense in which the potential size of the balance sheet'the shadow balance sheet, if you will'is very large.

The reason is that when the FOMC sets a target for the federal funds rate, it is sending very specific instructions to the folks from the Open Market Desk at the New York Fed, who run monetary policy operations on behalf of the FOMC. Those instructions are really pretty simple: If you have to inject more bank reserves (and hence expand the size of the Fed's balance sheet) to maintain the FOMC's funds rate target, do it.

To make sense of that statement, it is helpful to remember that the federal funds rate is an overnight interest rate that is determined by the supply and demand for bank reserves. Simplifying just a bit, the demand for reserves comes from the banking system, and the supply comes from the Fed. As in any supply and demand story, if demand goes up, so does the "price"'in this case, the federal funds rate.

In our hypothetical example, the Open Market Desk has been instructed not to let the federal funds rate deviate from 3 percent'at least not for very long. With such instructions, there is really only one thing to do in the case that demand from the banking system increases'create more reserves.

To put it in the terms of the business example I started out with, in setting a funds rate target the FOMC is giving the Open Market Desk the following marching orders: If customers show up, step up the production and meet the demand. The Fed's balance sheet in this case will automatically expand to meet bank reserve demand, just as the businessperson's inventory would expand to support the demand for widgets. As with the businessperson in my example, there is little difference between holding a large tangible inventory and standing ready to supply on demand from a shadow inventory.

Though the analogy is not completely perfect'in the case of the Fed's balance sheet, for example it is the banks and not the business (i.e., the Fed) that hold the inventory'I think the story provides an intuitive way to process the following comments (courtesy of Bloomberg) from Fed Chairman Ben Bernanke, from last week's congressional testimony:

"Raising interest rate on reserves" when the balance sheet is large is the functional equivalent to raising the federal funds rate when the actual balance sheet is not so large, but the potential or shadow balance sheet is. In both cases, the strategy is to induce banks to resist deploying available reserves to expand deposit liabilities and credit. The only difference is that, in the former case, the available reserves are explicit, and in the latter case they are implicit.

The Monetary Policy Report that accompanied the Chairman's testimony contained a fairly thorough summary of costs that might be associated with continued monetary stimulus. Some of these in fact pertain to the size of the Fed's balance sheet. But, as the Chairman notes in the video clip above, when it comes to the mechanics of exiting from policy stimulus, the real challenge is the familiar one of knowing when it is time to alter course.

By Dave Altig, executive vice president and research director of the Atlanta Fed

 

March 8, 2013 in Banking, Fed Funds Futures, Federal Reserve and Monetary Policy, Monetary Policy | Permalink

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One potential risk this time is that the Fed has been buying lots of assets that aren't treasuries, and some of the riskier assets can no longer be sold for the same price at which it was bought. In theory that situation could leave the Fed unable to recall all the money it put into circulation.

That said, you are right that interest on reserves could still be raised to have the same effects.

Posted by: Matthew Martin | March 08, 2013 at 03:30 PM

What the Dual Mandate Looks Like

« Nature Abhors an Output Gap | Main

March 01, 2013

What the Dual Mandate Looks Like

Sometimes simple, direct points are the most powerful. For me, the simplest and most direct points in Chairman Bernanke's Senate testimony this week were contained in the following one minute and 49 seconds of video (courtesy of Bloomberg):

At about the 1:26 mark, the Chairman says:

So, our accommodative monetary policy has not really traded off one of [the FOMC's mandated goals] against the other, and it has supported both real growth and employment and kept inflation close to our target.

To that point, here is a straightforward picture:

I concede that past results are no guarantee of future performance. And in his testimony, the Chairman was very clear that prudence dictates vigilance with respect to potential unintended consequences:

Highly accommodative monetary policy also has several potential costs and risks, which the committee is monitoring closely. For example, if further expansion of the Federal Reserve's balance sheet were to undermine public confidence in our ability to exit smoothly from our accommodative policies at the appropriate time, inflation expectations could rise, putting the FOMC's price stability objective at risk...

Another potential cost that the committee takes very seriously is the possibility that very low interest rates, if maintained for a considerable time, could impair financial stability. For example, portfolio managers dissatisfied with low returns may reach for yield by taking on more credit risk, duration risk, or leverage.

Concerns about such developments are fair and, as Mr. Bernanke makes clear, shared by the FOMC. Furthermore, the language around the Fed's ultimate decision to end or alter the pace of its current open-ended asset-purchase program is explicitly cast in terms of an ongoing cost-benefit analysis. But anyone who wants to convince me that monetary policy actions have been contrary to our dual mandate is going to have to explain to me why that conclusion isn't contradicted by the chart above.

By Dave Altig, executive vice president and research director of the Atlanta Fed

March 1, 2013 in Employment, Federal Reserve and Monetary Policy, Inflation, Monetary Policy | Permalink

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