Last week’s CPI number was not the wet blanket some investors had been hoping for. Even though the probability of a Fed hike decreased from around 80% to just over 70%, it’s going to take more than a soft monthly number to derail the June and the September hike. The surprise came in the decline of medical care prices, certainly not an easy accomplishment. The increase in shelter costs, on the other hand, was no surprise. The climb in rents has been steady as vacancy rates have fallen and supply is not keeping up with demand. This is likely to continue for some time as there appears to be shortages of affordable housing in markets where the jobs are being created. Build it and they will come just doesn’t work for housing.
This presents another challenge. One of our country’s best competitive advantages is labor mobility. Affordable housing enables our labor force to quickly fill the needed demand for labor in the locations it is needed. In the absence of affordable housing, these labor needs go unfilled and growth is curtailed. I suspect that the financial repression brought on by the crisis of 08-09 is part of the problem. Forgetting the past is surely the path to repeating it, but not learning from the present has its consequences as well.
Speaking of inflation, CPI is a good starting point. It’s the number grabbing the headlines. But any serious expert on the subject will quickly turn the conversation to the Fed’s favorite measure, PCE core deflator. CPI reflects a set basket of goods, while PCE takes into account the substitution effect for changing prices. To reflect this, PCE will usually rise at a slower pace than CPI. PCE is still running below the targeted 2% and wage pressure doesn’t seem to be exerting any undue pressure on the economy. So, what’s the hurry? Normalization.
For a long time, the Fed with a 0 – .25 % interest rate had little room to maneuver if there was any sign of trouble. And, with a balance sheet that makes the fat lady in the circus look tiny, options were limited. Things look better as we currently stand, but how the Fed communicates its plan to reduce the balance sheet will be worth watching. Inflation is not the only problem the Fed will have to deal with in the coming months.
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