Part of a central bank’s challenge in setting its policy rate lies in knowing which measure of inflation to follow. From the consumer price index to the personal consumption expenditures index, different measures of inflation can tell a different story.
By waiting for housing prices to moderate in traditional measures of inflation, the Fed risks keeping rates too high for too long and tipping the economy into recession.
On Friday, investors and policymakers will get a look at the Federal Reserve’s preferred measure of inflation, the PCE index.
The consensus forecast is that the PCE index will be flat for May and have a 2.6% increase from one year ago, while the estimate of the core PCE, which excludes the more volatile food and energy components, is for an increase of 0.1% on the month and 2.6% on a year-over-year basis. That consensus for overall PCE is in line with RSM’s forecast for 0.1% on the month and 2.6% on the year.
But traditional measures like CPI, and even PCE, don’t necessarily tell the full story of what is happening with inflation, especially in housing. By waiting for housing prices to moderate as the Fed tries to reach its 2% overall goal, the Fed risks keeping rates too high for too long and tipping the economy into recession.
That’s where other measures of inflation are instructive. Consider the harmonized index of consumer prices. The HICP measures the change in the price of goods and services paid by households over time that is harmonized across diverse economies such as the European Union and is broadly applicable to the large regional and state economies of the United States.
Like the CPI it is a basket of goods and services that is updated regularly that include food, clothing, gasoline, services and housing.
As tracked by the Bureau of Labor Statistics, HICP in the United States currently stands at 2% (or, more precisely, 1.95%)—lower than CPI or PCE.
If the Fed used HICP in setting its policy rate, we would be talking about the Fed joining the parade of global central banks cutting rates its meeting next month rather than waiting on further disinflation to appear in the PCE index.
The HICP explained
So what are the differences between the HICP and the better-known CPI and PCE?
First, the harmonized index includes the rural population; the CPI, by contrast, focuses entirely on urban residents, who make up 87% of the American population.
Second, and more important, the CPI and PCE exclude owner-occupied housing costs—each index has different weights for housing—and creates what is called the owner’s equivalent rent series, which attempts to identify the cost of shelter service that a housing unit provides to its occupants. The basic idea is that it attempts to measure the ongoing consumption of housing services in contrast with the change in the value, or price, of the home itself.
This fictive metric attempts to estimate the imputed rent that owners would pay if they were renting their homes excluding furnishings and utilities. This metric does not include things like mortgage interest, tax, fees, home improvement or maintenance of the capital good in the estimate of housing inflation.
The HICP approach, by contrast, measures the cost of owner-occupied housing by focusing on the cost of acquisition. That cost includes the price of new and existing homes bought by individuals for their own use, excluding investment properties, and also includes the cost of repairs and improvements. Mortgage interest rates are considered financial transactions and are not included inside the harmonized index estimate of inflation.
Essentially, the harmonized index measures actual housing costs, while the consumer price index measures an estimate of what the Bureau of Labor Statistics thinks home owners pay. In the end, CPI is a good-faith estimate.
There is a risk to using owner’s equivalent rent in calculating overall inflation. Should the Fed hold rates too high for too long as it waits for disinflation to show up in the CPI data, it risks prematurely ending the business cycle based on a fictive metric of housing inflation.
Housing inflation, along with services-based prices, is the primary cause of the difference in the Fed’s policy variable—the PCE index—at 2.6% and the HICP at 2%.
Read more of RSM’s insights on inflation, the economy and the middle market.
This difference is well-known among central bankers and economists. While the Fed will not be using the harmonized index to officially make policy during this business cycle, it should consider harmonizing its policy framework with the other central banks after this cycle ends.
This is one reason why we have consistently pointed out the vast difference in what a near real-time housing metric such as the Cleveland Fed’s new tenant rent index shows, and in what appears in the CPI and PCE, which operate with a 12- to 18-month lag.
This lag has resulted in the Fed waiting to see the whites in the eyes of disinflation and risks a policy error that if carried on too long will tip the economy into an unnecessary recession.
The takeaway
The different inflation metrics used by the Federal Reserve, Bank of England and the European Central Bank are resulting in a divergent reaction function and interest rate policies.
Rate cuts by the European Central Bank and those that we think the Bank of England will start in August are already causing a divergence in currency valuations. The U.S. dollar is up strongly against 15 of the 16 major trading currencies this year. And the divergence is a reason that roughly 30% of international currency flows are heading for U.S. markets and its higher rate of returns.
