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Why Core Inflation May Fall Further Than Expected

The minutes of the Federal Reserve's September board meeting, issued in mid-October, contained some forecasts/predictions about future inflation rates that are worth exploring, specifically:

Most participants anticipated that slack in both labor and product markets would be substantial over the next few years, leading to subdued and potentially declining wage and price inflation.

With the significant under-utilization of resources expected to persist through 2011, the staff forecast core inflation to slow somewhat further over the next two years from the pace of the first half of 2009. [Author's note: The core inflation rate of the first half of 2009 was 1.8%]

A few preliminary observations are in order. The minutes reflected the public dispute among board members concerning the prospects for future inflation but indicated that "most participants" believe inflation over the "next few years" would be "subdued and potentially declining." The staff predicted that core inflation would decline further "over the next two years." Such long-term predictions on inflation rates are unusual in the Fed minutes but these predictions drew almost no attention in the financial press.

The minutes did not say whether the staff believed that core inflation rates would fall below the Fed's target range of 1.5% to 2.0%, announced in 2008. Even if the staff held that opinion, it is unlikely that it would have been included in the minutes, which are in significant part a public relations tool intended to influence financial markets. Such a statement would have given support to those commentators arguing that deflation is a serious threat which could cool markets and delay a recovery.

Some prominent commentators have indicated that core inflation will fall below the target range. In October, Nobel Prize economist Paul Krugman stated, "Suppose that core inflation stays at 1.6% [the then current annual rate], although in fact it's almost sure to go lower." Jan Hatzius, the highly respected Chief Economist at Goldman Sachs, concurs, "We have core inflation falling through next year to close to zero."

During the past decade core inflation has ranged from a high of 2.6% in 2006 to a low of 1.4% in 2003 and has averaged 2.2%.

The Fed has repeatedly indicated, when making interest rate decisions, that core inflation is more important than headline inflation, which includes volatile food and energy prices.

The devil is in the details and a critical detail of core inflation is the "rental" component. "Rent" makes up approximately 40% of core inflation and is by far the largest component of the index. Eight percent of the core inflation index is the amount actual renters pay. Thirty-two percent of the index is the "owners' equivalent rent" - the amount that the government estimates owners would pay in rent for their residences. Counterintuitively, since 1983, the actual price of homes and the amount of mortgage payments have played no role in government inflation indexes.

September's inflation report indicated a decrease in both the rent and owner equivalent rent price components. For the first time in the past 17 years, these components registered small, but significant monthly declines. Over the past decade, these component sub-indexes have averaged between 0.2% and 0.3% monthly growth. In September, both sub-indexes registered 0.1% declines. For the past three months, the two sub-indexes combined have been flat - no growth whatever. Growth in these component indexes slowed in February and came to a halt in June before turning negative this past month.

A variety of factors have contributed to the decline in the rental sub-indexes. There are a record number of vacant housing units - the vacancy rate for the third quarter 2009, is 11.1%- the highest level since the Census Bureau began collecting data in 1956. It is almost certainly the highest vacancy rate since the Great Depression. The rate exceeds 15% in 10 of the 75 Metropolitan Statistical Areas, including Atlanta, Austin, Indianapolis, Phoenix, Cleveland and Richmond. Overbuilding during the housing bubble has created an excess supply of both single family homes and apartment units (some of which developers have converted from condominium projects). High unemployment has resulted in younger tenants doubling up, some returning home to live with parents and a slower level of household formation. Tax incentives for first-time buyers as well as enhanced housing affordability due to falling prices have made homeowners of some renters. All these factors have contributed to increased rental vacancies, putting downward pressures on rents.

Prominent real estate research firm Reis, Inc. predicts that apartment vacancy levels will climb further during the next two quarters.

An open question is whether we will experience the first year-over-year decline in the rental components since the owners' equivalent component was created in 1983. Prior to the collapse of the housing bubble, many commentators saw that housing prices had climbed year-over-year for more than 50 years and predicted they would continue to do so. The housing bust proved their predictions wrong. The inflation rental indexes may now be the next domino to drop. A year-over-year decline in those indexes would significantly increase the risk of zero percent core inflation or outright deflation.

There has been a clear downward trajectory in rents and owners' equivalent rent over the past three years. That trajectory and momentum are unlikely to reverse as long as the unemployment rate climbs. Most economists believe that the unemployment rate will exceed 10% in early 2010 and thereafter decline. Increasing rents and falling vacancies are likely to lag the peak in unemployment by several months while the newly employed tentatively enter the housing market. If rents stay flat in the coming two years, core CPI would almost certainly fall below the Fed's target range. If rents were to further decline for a year or two, there would be a serious threat (35% to 40% chance) of outright deflation in the core index. At present, the most likely scenario is that the rental indexes will be flat for at least a year. For investors, this situation diminishes the chances of significant increases in the Fed Funds rate from their near zero current level during the coming year.


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