The Tweet was the first thing that caught our attention. When Mark Zandi, co-founder of Economy.com and chief economist for Moody’s Analytics, makes a statement on the Federal Reserve’s rate cut policy, it’s impossible (apparently) to just scroll on past it.
In the Tweet, Zandi referenced a report by the Federal Reserve Bank of Minneapolis, which urged the same solution he argued for in a Washington Post op-ed he co-wrote with Jim Parrott.
Take a look at this important recent paper by researchers from the Minneapolis Federal Reserve: https://t.co/oVXUjsh8Sq The researchers conclude that the “optimal (monetary) policy should largely ignore shelter prices and target price stability in the non-housing sector.”…
— Mark Zandi (@Markzandi) July 29, 2024
On today’s Hot Sheet, Byron Lazine broke down the key details of the report and op-ed, tying together previous research and expert insights as the Fed prepares for tomorrow’s FOMC meeting.
Read on for the highlights.
Highlights from the Minneapolis Fed report
The recent surge in housing costs, and specifically rents, has contributed to inflation remaining above target in many countries, including the U.S.
Advanced economies across the globe saw a rapid rise in inflation post-COVID, and central banks have responded by tightening monetary policy. Nearly two years later, inflation remains above the Federal Reserve’s 2% target, primarily due to housing inflation.
The models used to track and measure inflation could also be at the root of inflation’s stickiness. Traditional Keynesian models assume production is based on consumer demand. But that doesn’t really apply to housing, where consumption is more supply-driven, since it takes time to increase housing supply by building more homes. Consumption of supply necessarily depends, at least in the short term, on the amount of housing available.
The Federal Reserve Bank of Minneapolis therefore argues in its report that the optimal monetary policy should prioritize stabilizing the non-housing sector and largely ignore housing.
Following a spike in housing demand (which we could expect from a significant drop in mortgage rates), central banks are faced with a trade-off: allow the housing market to overheat or tighten policy and risk slowing down the goods sector.
Using both simple and dynamic models, the report by the Minneapolis Fed demonstrates how its recommended policy would work by focusing on stabilizing the goods sector and disregarding housing inflation.
The report compares three different monetary policy responses to a surge in rents:
- CPI-targeting—sets CPI inflation to zero
- Goods inflation targeting—sets goods market inflation to zero
- Optimal policy—aims to maximize overall well-being for households while considering the natural balance and functioning of the economy
According to its models, the optimal policy is almost identical to goods inflation targeting, allowing CPI inflation to rise after a significant increase in housing demand.
The Minneapolis Fed’s findings suggest a need for central banks (including the U.S. Federal Reserve) to reevaluate the measure of inflation they’re targeting and to focus more on sectors with demand-determined output, placing less weight on supply-determined housing inflation.
Response from Mark Zandi of Moody’s Analytics
Zandi’s Tweet gets right to the point in its response to the Minneapolis Fed’s report:
“Take a look at this important recent paper by researchers from the Minneapolis Federal Reserve. The researchers conclude that the “optimal (monetary) policy should largely ignore shelter prices and target price stability in the non-housing sector.” Exactly the point I made with Jim Parrott in this Washington Post op-ed. Of course, the Fed researchers came to this in a much more elegant and rigorous way. Hopefully, their Fed colleagues who set monetary policy heed their advice. If they do, they have a bright green light to begin cutting rates as non-housing inflation is already firmly at or even below the Fed’s target.”
Byron Lazine responded to the Tweet in Tuesday’s Hot Sheet:
Thank you, Mark! …We’ve been making this point on the Hot Sheet all year and into last year. So glad somebody like Mark Zandi is saying it, putting out a Tweet that’s getting attention pre-FOMC…Hopefully, somebody forwards this to J Powell.
Watch the full breakdown here:
Highlights of the Washington Post op-ed
Zandi and Parrott’s op-ed in the Washington Post is another must-read for anyone wanting a clear-eyed look at how we measure inflation in the United States, specifically with regard to housing.
Starting with some background on inflation and interest rates in the U.S., the op-ed zooms in on the flawed measures of housing costs relied on by the Federal Reserve to determine whether inflation has reached its 2% target.
In a nutshell, the personal consumption index (PCE), which is the Fed’s fave measure of inflation, as well as the consumer price index (CPI) rely on owners’ equivalent rent (OER) as a tracking metric for housing costs.
Zandi and Parrott explain exactly why this metric is all but useless and, worse, misleading for a metric so disproportionately represented in inflation measures.
They also lay down the facts supporting the argument that, if the Fed measured inflation the way most developed countries now do, it would find inflation has reached the 2% target—and has been there since last fall.
The higher-for-longer approach seems more cautious and well-considered, until you look deeper.
From the Op-Ed:
“High interest rates have made the situation still worse by making it harder and more expensive for builders and developers to finance new construction. Added to the still-elevated costs of land, labor and materials, they have made building new homes simply too expensive in many parts of the country. Moreover, higher rates are making many homeowners understandably reticent to give up their much lower mortgage rate and put their homes on the market.
“This breakdown in the housing supply pipeline is lifting the cost of buying and renting, driving up the very measure of inflation on which the Fed is relying. The tool the Fed is using to drive inflation down is doing precisely the opposite…”
Byron also reviewed and commented on the op-ed, highlighting key points that drive home the same message to the Federal Reserve. We can only hope they get wind of this before deciding tomorrow whether or not to start rate cuts.
The op-ed revealed two fatal flaws in the owners’ equivalent rent (OER) metric—in a manner similar to the way Byron has explained it multiple times on the Hot Sheet.
Ultimately, Zandi and Parrott argue for a new monetary policy similar to what the rest of the developed world uses to track and moderate inflation.
Granted, it does put the Fed in a tricky position. Changing the way it tracks inflation mid-course would doubtless mean months of Q&As and presentations to explain the course correction—and to acknowledge that their previous tracking methods were misleading.
Sticking with its current plan, though, could ultimately do more damage to their reputation, not to mention the U.S. economy.
I’m glad that the (Washington Post) put this op-ed out there. It happens to be very accurate… Mark Zandi from Moody’s talking about it in his Tweet [which is] getting some attention on X—and obviously now the Federal Reserve Bank of Minneapolis is on board with this and has a big white paper that…the FOMC will hopefully take into consideration.
