Pandemic Economics, Housing and Monetary Policy: Part 2

Special Note: This was mostly written prior to the failure of Silicon Valley Bank. Now it appears the Fed might pause in March. Goldman Sachs economists wrote last night: “we no longer expect the FOMC to deliver a rate hike at its next meeting on March 22 (vs. our previous expectation of a 25bp hike)”, although BofA economists wrote this morning “After the latest developments around Silicon Valley Bank and the Fed, we retain our outlook for a 25bp hike in March.”

In Part 1 of Pandemic Economics, Housing and Monetary Policy I noted that pandemic economic outcomes were frequently largely unexpected. And that this has been especially true for housing.

Housing is the key transmission mechanism for monetary policy. And we need to be on the lookout for pandemic distortions to normal economic patterns - especially in housing - and hope that the Federal Open Market Committee (FOMC) will adjust monetary policy accordingly.

Many analysts are puzzled about why the economy hasn’t slowed quicker given the rapid increase in the Fed Funds rate over the last year. Some analysts are even concerned about “premature reacceleration”. Goldman Sachs economists wrote last week:

“In recent months we have argued that the drag on GDP growth from last year’s fiscal and monetary policy tightening is fading, not growing, and that this means that the key risk for the economy is a premature reacceleration, not an imminent recession.”

emphasis added

When I read some of the recent comments from FOMC members, I’m reminded of a great scene from the movie China Syndrome where a stuck indicator almost led to catastrophic failure. From the China Syndrome script:

High water level in the reactor!

Okay, relax. Everybody relax. Dump the water.

It's just a routine turbine trip.

Find out where that water's coming from. We've got to get rid of it.

…

Jack! Look at this water level indicator. It's low.

This says it's high. But that's ... Jesus Christ! Barney, give me feedwater.

Ted, we may uncover the core.

Operations.

Jack Godell. We have an emergency. Get everybody into safety areas.

Some FOMC members are shouting “high level water in the reactor” (Fed Funds rate too low). They keep turning the knob and wondering why nothing is happening. But perhaps the indicator is stuck, and after adjusting for pandemic distortions, the water level may already be OK.

A key question: the FOMC claims to be “data dependent”, but are they appropriately adjusting the data for pandemic economic distortions?

Has the Lag from Monetary Policy Shortened?

Historically, analysts and the Fed have argued that the lags from monetary policy are “long and variable”. More recently, the consensus at the Fed and among many analysts is that the lag from monetary policy has shortened.

In December 2022, economists at the Kansas City Fed wrote: Have Lags in Monetary Policy Transmission Shortened? They argued that forward guidance has shortened the lag between changes in monetary policy and financial tightening since 2009. This appears to be correct.

They also argue that it appears the lag has shortened on the impact on inflation, but it is unclear on employment. And last week, Professor Krugman tweeted (the graph is housing units started vs residential building employment):

Paul Krugman @paulkrugman

The most puzzling chart in economics right now. Much speculation about why Fed hikes haven't done much to slow the economy, but too much focuses on businesses and consumers; housing is where monetary policy usually has the most traction 1/

First, construction employment is still increasing, up another 24 thousand in February, even though housing starts have decreased significantly. The reason employment hasn’t fallen is there are still a near record number of housing units under construction - due to ongoing supply chain delays (pandemic economics!). The following graph shows housing units under construction, Seasonally Adjusted (SA).

Red is single family units. Currently there are 752 thousand single family units (red) under construction (SA). This was down in January compared to December, and 76 thousand below the recent peak in April and May 2022. Single family units under construction have peaked since single family starts are now declining.

Blue is for 2+ units. Currently there are 948 thousand multi-family units under construction.  This is the highest level since November 1973! Combined, there are 1.700 million units under construction, just below the all-time record of 1.711 million set in October 2022.

And there are many industries that follow new construction - appliances, furniture and many more. I’ve been tracking the lead times for several items. A major window supplier told me their lead time was close to 6 months in December, 5 months in January, and now about 3 1/2 months. What happens in late summer? Layoffs. The same is true for some of the appliance manufacturers - their lead times are still long but shortening quickly.

This suggests that the employment indicator is currently “stuck” - due to lingering pandemic impacts - and that the housing related job losses are already in train and will likely start in the 2nd of 2023. It appears to me that the lag from changes in monetary policy to unemployment are currently longer than normal.

This is an out of consensus view, but likely correct.

What about the Lag to Inflation?

The pandemic impact on the lag of monetary policy to inflation is less clear.

Many analysts have noted that there is a lag between new rental rates and renewal rental rates, since renewal rates usually only change annually. And this lag has kept pushing up the BLS and BEA measures of shelter, even as new rental rate growth has slowed sharply, since the government measures track more with renewal rates. Here is a graph of the year-over-year change in shelter from the CPI report and housing from the PCE report (both through January 2023):

But that lag is just part of the shelter inflation story.

As I noted in Part I, a key driver of earlier new rental increases was a surge in household formation that I deduced from the data in 2021: see Household Formation Drives Housing Demand.

More recently household formation has slowed sharply.

So, demand has decreased, just as a large number of apartment units are about to come on the market (all those unit under construction). And we are already seeing asking rents down year-over-year in some areas, and we might see asking rents down nationally YoY soon.

In the Fed’s Beige Book released last week, the Richmond Fed noted:

“Leasing rates for multifamily were starting to decrease, particularly for mid-priced units; high end apartment rents were unchanged.” emphasis added

The Fed is aware of this issue and Fed Chair Powell has been looking at service inflation ex-shelter. The following graph shows the YoY price change for Services and Services less rent of shelter through January 2023. Services were up 7.6% YoY as of January 2023, and Services less rent of shelter was up 7.2% YoY.

In calculating CPI, according to the BLS weights, services are 61.8% of total CPI, and services less rent of shelter is 27.6% of total CPI. Shelter alone is 34% of CPI. These are key components of CPI.

The above graph would seem to suggest that the Fed has more work to do, since there is a concern that service inflation might be more persistent than goods inflation. But once again, I think the indicator might be stuck for three reasons:

1. To the extent that inflation tracks unemployment - and increases in unemployment are just delayed - won’t service inflation slow later this year?

2. And what evidence do we have that service inflation will be more persistent than goods inflation? Here is graph of YoY price changes for “Commodities less food and energy commodities” (21.4% of total CPI) and “Services less rent of shelter” (27.6% of CPI). As I noted in Part I, early in the pandemic we saw a surge in good prices, as many services were shut down. And then in 2021 and 2022, we saw a shift from goods back to services. Perhaps service ex-shelter will have a similar slowdown as for commodities. It appears that disinflation has started.

3. And finally, the Fed is now looking at services ex-shelter, but they still might be underestimating the impact from the slowdown in household formation and coming surge in multi-family supply.

The Monetary Policy Risks

There are monetary policy risks in both directions - doing too much and doing too little.

If the Fed doesn’t tighten enough in the near term, inflation might become embedded, and the Fed would then have to raise rates even higher since the Fed’s inflation fighting credibility might be questioned.

However, if the Fed tightens too much, then 1 to 2 million people - and maybe more - might lose their jobs unnecessarily.

My view is the Fed could pause soon with a clear message that they understand some of the data is lagged due to pandemic economics, and if inflation doesn’t decline, they will raise rates further later this year. A middle path.

Bottomline: It seems to me the risks of a policy error are increasing.