July 17, 2022

The Fed Must Now Target “Good” Inflation

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Bottom Line:


The US Consumer Price Index rose a blistering 9.1% in June. Within the report, energy prices increased 41.6%, food prices increased 10.4%, with all other prices increasing 5.9%. Fortunately, the recent collapse in commodity prices (energy and food) suggests that this may be the peak inflation report for the cycle. Unfortunately, “stickier” rent inflation rose 5.6%, much higher than levels reached during the 2008 housing bubble and well beyond the Fed’s comfort zone. For the Fed to reach its 2% inflation objective, real estate rents must come down. This means real estate prices must come down. In 2008, declines in real estate prices nearly imploded the entire financial system. With house prices poised to decline… are we on the verge of another Great Financial Crisis?


The Full Story:


By mandate, Congress holds the Federal Reserve responsible for general “price stability.” Congress does not hold the Federal Reserve responsible for “asset price stability.”  Therefore, Fed officials largely ignore price gyrations in stocks, houses, bitcoin prices, etc. when setting policy, other than as anecdotal input. For instance, excessive valuations on the NASDAQ back in 1996 triggered Greenspan to coin the term “irrational exuberance,” and yet the federal funds rate remained constant. The Fed also largely disregarded the housing bubble in the late 2000s as general inflation levels were mostly within their target range. In fact, most Fed officials see asset price inflation as “good” inflation, and general price inflation as “bad” inflation. Therefore, as long as “bad” inflation behaves, “good” inflation can rise indefinitely.


Jerome Powell’s forceful response to the COVID pandemic led to the largest amount of monetary stimulus in history. The response in the asset markets was immediate. Between March of 2020 and January of 2022, crypto prices rose 1000%, stock prices climbed 100% and house prices rose 40%. These extreme advances led to a 30% surge in household net worth across the United States, the strongest advance in US history.


That is not “good” inflation, that’s “GREAT” inflation!


Unfortunately, excessive stimulus, supply constraints, and COVID shutdowns also ignited “bad” inflation, the most concerning and consequential of which is rent inflation. Rent inflation accounts for over a third of headline inflation and typically lags real estate price increases considerably. For example, housing prices began shooting higher around June of 2020, and yet rent inflation continued falling until February of 2021. It has grown steadily ever since.


In the most recent report, rent inflation rose 5.6%. That’s the largest annual increase since 1990. Even in the housing bubble of the late 2000s, rents didn’t rise this much. While the link between a hot stock market and hot inflation isn’t clear, the link between a hot housing market and hot rent inflation makes the link to general inflation crystal clear. Unfortunately for homeowners, for the Federal Reserve to whip today’s “bad” general price inflation, they need to whip the “good” asset price inflation in housing.


Setting their Sights


Over the last twelve months, house prices across the United States of America rose 20%. This escalation dusts the 9% peak annual increase seen at the height of the housing bubble. For visual reference of how extremely generous this environment has been to homeowners, see below:


Picture1 1


For buyers, it’s a different story. While house prices have risen 20%, wages have only risen 5%, making ownership a stretch. To compound the difficulty, mortgage rates have doubled so far this year. Taken together, housing affordability for purchasers has cascaded to record lows:




In theory, with housing affordability at record lows, prices paid should begin declining and listings should rise as sellers panic and buyers strike. Let’s test the theory.


Nashville, TN has been one of the hottest residential real estate markets in the country. The All-Transactions Price Index for Nashville shows a 27% increase year over year, well above the national average (for comparison, during the housing bubble, Nashville home prices peaked at a measly 9% growth rate). The median sale price for a home in Nashville recently hit a record of $460,000 against the national average of $428,000.


According to Redfin data released this week, the winds have changed. The median sale price for a Nashville home ticked lower by 2% in June. Nashville homeowners must be well attuned to price trends as the number of home listings also rose 16% last month and stand 30.5% higher than this time last year.


Theory proven.


Nationally, the numbers are more sedate, but directionally consistent. The number of homes for sale nationally grew 2% overall in June, the first annual increase since July of 2019. The total number of homes sold fell 16% and listings rose 2.4%. Based upon these trends, consistent with the Fed’s mandate, real estate disinflation has begun. How far will prices fall? Unknown. But for reference, publicly traded real estate investment trust indices have fallen 20% year to date, while home values lost 30% during the Great Financial Crisis.


Before you yell “CRISIS!” know this: homeowners are much better positioned going into a price correction than they were in 2008. Examine the chart below showing homeowner equity levels:


Picture3 1


This means that the Fed can force down house prices without imperiling homeowner solvency. Additionally, the US banking system reforms instituted after the crisis forced banks to fortify balance sheets. All 33 banks recently stress-tested by the Fed passed easily.


The Fed needs general price levels to fall. Consequently, they have raised rates aggressively and begun quantitative tightening to restrict aggregate demand. Asset markets have responded. Crypto markets have fallen 80%, the stock market has fallen 20%, and the bond market has fallen 10%. The housing market has yet to correct, yet it holds the most direct relationship to general inflation through rent computations. The Fed needs rental rates to fall as they comprise the highest weighting in inflation indices. This will require real estate prices to fall. Fortunately, homeowners and banks have strong enough balance sheets to withstand price declines… without triggering another Great Financial Crisis.


Have a great Sunday!


David S. Waddell 
CEO, Chief Investment Strategist




Sources:  FRED, GS Housing Affordability Index


David Waddell
Author: CEO Chief Investment StrategistAfter graduating from the University of the South with a BA in Economics, David began his career with Charles Schwab & Co., Inc. in Phoenix, AZ. Having been recognized for his outstanding business development record, David was promoted to the San Francisco- based Institutional Strategic Accounts Team, which interfaced with the Big 5 accounting firms and Schwab’s largest customers. David left Schwab to continue his education at the graduate level in Boston. While earning his MBA degree with a concentration in finance and investments at the F.W. Olin School at Babson College, he was appointed by the college Trustees to manage a team of seven portfolio managers overseeing the student-managed portion of Babson’s endowment fund. David also founded the Babson Investment Management Association to assist undergraduate and graduate students with training and career path planning in the investment management field. As the firm’s Chief Investment Officer, David chairs the W&A investment committee and combines macro economic forecasting, macro market analysis and macro risk assessments to design portfolio strategies utilizing public market securities worldwide. A civic leader in Memphis, David currently acts as Chairman of Epicenter Memphis, and Co-Chair of the Memphis Chamber Chairman’s Circle while also serving as a board member for LaunchTN and the New Memphis Institute. David previously served as chairman for The Leadership Academy, the RISE Foundation, and the Economic Club of Memphis. He also chaired the capital campaign to build the “Live” stage at the Memphis Botanic Garden. David was a member of the 2004 Leadership Memphis class and has been recognized as one of Memphis’ “Top 40 under 40” by the Memphis Business Journal, and as a finalist for “Executive of the Year” in 2007. In addition to weekly columns in the Memphis Daily News and the Nashville Ledger, David has appeared in the Wall Street Journal, USA Today, Forbes, Business Week, Investment News, Institutional Investor News, The Tennessean and Memphis Business Journal. He has also made appearances on Fox Business News, Yahoo Finance, Bloomberg TV, CNBC, and CBS News and ABC News Channels. Read some of David's articles on his author page in Inside Memphis Business. David has two wonderful children, Easton and Saylor, an obedient Labradoodle named NASDAQ, and a devoted Goldendoodle named Ripley.


David S. Waddell


Chief Investment Strategist

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