Even as the Fed laments that inflation as measured by either the hedonically adjusted CPI, or the PCE deflator measure (which on any given month is whatever a seasonal adjustment excel model says it is), is persistently below its long-term target of 2%, one component of the broader CPI basket has quietly continued risen to new multi-year highs. That would be the so-called owners’ equivalent rent (OER), which is the biggest component of the CPI, and measures imputed costs of renting one’s own home: it is currently the highest it has been since 2008.
However, while it accounts for a whopping 23.9% of the CPI basket, OER has a far smaller share or 11.3% of the Fed’s preferred inflation metric, the PCE deflator.
Bank of America observes that over long periods of time OER and the rest of the CPI should tend to move together, reflecting overall inflation — that is, changes in the purchasing power of a dollar. However, in recent years that has been anything but the case, with OER now the highest since the Lehman crisis and rising ever higher even as the Non Shelter Core CPI continues to decline.
To be sure, the surge in rent prices to record highs is nothing new, and should be familiar to Zero Hedge readers. After all we presented just this a few short months ago:
Still, this divergence between rising rental inflation and disinflation in everything else has led Bank of America to ask whether as some analysts expect, an abrupt reversal in inflation is due with surprises to the upside. BofA cites said analysts who point to “special factors” that have either temporarily depressed inflation or are poised to jump higher very soon. Some of these stories have difficulty explaining why inflation has been so low for the past few years — those are rather persistent “temporary” factors.
At this point BofA points out that while in the short-term the divergence between the series is indeed notable, over the longer-term the two datasets eventually converge:
That co-movement can be seen clearly in Chart 1: since the user cost concept of OER was incorporated into the CPI in 1983, the correlation between the annual inflation rates in OER and the non-shelter core CPI has been 0.63. This strong positive relationship largely reflects the general downward trend in inflation since the early 1980s, as the Fed consolidated the credibility gains from the Volcker disinflation and as other macro factors (such as globalization and the decline of collective bargaining and wage indexation) helped restrain price growth.
Look a little more closely at Chart 1, however, and it becomes apparent that there are several periods in which OER goes up — at least for a short time — but then reverts back to trend. Thus, it can be a misleading indicator of inflationary pressure in the medium term. More importantly, these times are typically ones in which the rest of the core CPI index falls as OER rises. This pattern is particularly clear in Chart 2. Since the peak of the housing bubble, the correlation between OER and non-shelter core CPI inflation actually has been negative: -0.29, in fact.
What is Bank of America's conclusion about this
We can make this intuition more rigorous by separating the two inflation series into a longer-run trend and a cyclical component. The low-frequency trend in inflation likely varies over time, as inflation expectations and more persistent economic factors (such as globalization, as noted above) are not constants. We estimate these trends using an unobserved components model over the full sample of available data. Not surprisingly, the time-varying trends are highly correlated: 0.79. This correlation coefficient is larger than for the two individual series as the model isolates the common long-run determinants of inflation.
Conversely, the cyclical components as identified by this procedure are negatively correlated, albeit not significantly so for the full sample: about -0.03. Looking just at the post-bubble period, the correlation drops to -0.33. Thus, if anything, high OER has been an indicator of lower, not higher, inflation. What is going on? In a nutshell: tight household budget constraints.
And there you have New Normal Paradox 101.
In its attempt to reflate asset prices at all costs, and succeeding with both the stock market and new housing bubble if not so much wages and the broad economy, the Fed has made housing unaffordable for the vast majority of the population (confirmed further by the plunge to 15 year lows in mortgage applications), forcing Americans to scramble for rental housing, sending rents to all time highs. This can be is seen in the OER. The problem is that with so much of monthly discretionary spending going to rental, it means there is far less in free cash flow available to be used for other purchases. Which also means that inflation away from rents is declining and getting lower with every month almost as a result of the surge in rents!
Continuing with Paradox 101: if indeed the Fed wants to stimulate broad inflation and boost the economy with a stable and achievable 2% inflationary target, it should pop the housing and rental bubbles, and send prices for this component of the CPI basket plunging, affording consumers more discretionary cash flow for other purchases.
Sadly, the Fed, comprised of clueless economist PhD hacks, will never figure this out, and instead will ponder and wonder how it is possible that month after month even more broad deflation appears to be setting in. Of course, it only needs to look at the culprit - every period the incremental inflation is being eaten up by the monthly rental paycheck. Sadly, it won't, and certainly not before it is too late, and this too housing bubble bursts uncontrollably. By then, then there will be bigger fish to fry, than wondering where all the inflation has gone.