Rent Prices Stickiness and the Latest CPI Data.

Fear of increasing inflation in the U.S. appear to be the trigger behind the market volatility of previous weeks. Recent gains in hourly compensation to workers have had analysts measuring the effect of wages on inflation. In turn, analysts began pondering changes in Fed’s monetary policy due to the apparent overheating path of the economy; which is believed to be mostly led by low unemployment rate and tight labor markets. Thus, within the broad measure of inflation, the piece that will help to complete the puzzle comes from housing market data. Although the item “Shelter” in Consumer Price Index was among the biggest increases for the month of January 2018, for technical definitions, its estimation does weight down the effect of housing prices over the CPI. Despite the strong argument on BLS’ imputation of Owner-Occupied Equivalent Rent, I consider relevant to take a closer look at the Shelter component of the CPI from a different perspective. That is, despite the apparent farfetched correlation between housing prices and market rents, it is worth visualizing how such correlation might hypothetically work and affect inflation. The first step in doing so is identifying the likely magnitude of the effect of house prices over the estimates and calculation of rent prices.

Given what we know so far about rent prices stickiness, Shelter cost estimation, and interest rates, the challenge in completing the puzzle consists of understanding the linking element between housing prices (which are considered capital goods instead of consumables) and inflation. Such link can be traced by looking at the relation between home prices and the price-to-rent ratio. In bridging the conceptual differences between capital goods (not measured in CPI) and consumables (measured in CPI) the Bureau of Labor Statistics forged a proxy for the amount a homeowner ought to pay if the house was rented instead: Owner-Occupied Equivalent Rent. This proxy hides the market value of the house by simply equaling nearby rent prices without controlling by house quality. Perhaps, Real Estate professional can shed light onto this matter.

The Setting Rent Prices by Brokers.

It is often said that rental prices do not move in the same direction as housing prices. Indeed, in an interview with Real Estate professional Hamilton Rodrigues from tr7re.com, he claimed that there is not such a relationship. Nonetheless, when asked about how he sets prices for newly rent properties, his answer hints at a link between housing prices and rent prices. Mr. Rodrigues’ estimates for rent prices equal either the average or the median of at least five “comparable” properties within a mile radius. The key word in Mr. Rodrigues statement is comparable. As a broker, he knows that rent prices go up if the value of the house goes up because of house improvements and remodeling. Those home improvements represent a deal-breaker from the observed stickiness of rent prices.

For the same reason, when a house gets an overhaul, one may expect a bump in rent price. That bump must reflect in CPI and inflation. I took Zillow’s data for December of 2017 for the fifty U.S. States, and run a simple linear OLS model. By modeling the Log of Price-to-Rent Ratio Index as a dependent outcome of housing prices -I believe- it will be feasible to infer an evident spillover of increasing house prices over current inflation expectations. The two independent variables are the Logs of House Price Index bottom tier and the Logs of House Prices Index top tier. I assume here that when a house gets an overhaul, it will switch from the bottom tier data set to the top tier data set.

Results and Conclusion.

The result table below shows the beta coefficients are consistent with what one might expect: the top tier index has a more substantial impact in the variation of the Price-to-Rent variable (estimated β₂= .12, and standardized β=.24, versus β=.06 for the Bottom tier). Hence, I would infer that overhauls might signal the link through which houses as a capital goods could affect consumption indexes (CPI and CEI). Once one has figured the effect of house prices on inflation, the picture of rising inflation nowadays will get clearer and more precise. By this means predictions on Fed tightening and accommodating policies will become more evident as well.

The Missing Part of the Dow Jones and Stock Market Sell-off Analysis.

The stock market keeps on sending signals of correction as the Dow Jones struggle to rebound from Monday’s 5th of February sell-off. Economic analysts began early in the week to point out to fear of high inflation due to an upward trend in workers compensation. News reports were mostly based on strong beliefs and arguments over the so-called Phillips Curve. However, instead of focusing exclusively on the weak relationship between wages and inflation, I suggest a brief look at the textbook explanation of the link between the stock market and economic activity. In this blog post, I frame the current market correction phenomenon under the arbitrage argument. If one were to consider the arbitrage argument to explain the correction, it would lead analysts to make firm conclusion not only over monetary policy but also over fiscal policy. The obvious conclusion is that Monetary Policy (Interest rates) will most likely aim at offsetting the effects of Fiscal Policy (Tax cuts).

The Arbitrage Argument (simplified):

Market sell-offs unveil a very simple investment dilemma: bonds versus stocks. In theory, investors will opt for the choice that yields higher returns. Firstly, investors look at returns yield by the interest rates, which means a safer way to make money through financial institutions. Secondly, investors look at returns yield by companies, in other words: profits. If such gains yield higher returns than saving rates, investors will choose to invest in the former. In both cases, agreements to repay the instrument will affect the contract and the financial gains, but that is the logic (Things can get messier if one includes the external sector).

The corresponding consequences are the market expectations about the economy. On the one hand, currently investors expect monetary policy to tighten. On top of jobs reports and previous announcement about rate increases, fears of inflation lead to the conclusion that the Federal Reserve Bank will most likely accelerate the pace in rising interest rates for its ten years treasury bond. Such policy will decrease the amount of circulating money, thereby making it harder for business to get funds because, following the arbitrage framework, investors will prefer to invest in safer treasury bonds. On the other hand, investors expect fiscal policy to have an impact on the economy as well. Recent corporate tax cut bolster the expectation for a higher level of profits from the stock market. Such policy may allure investors to believe that financing companies through Wall Street will yield higher returns than the bond market. Thus, sell-offs unveil the hidden expectations of investors in America.

Expectations and the Economy:

Once expectations seem formed and clear concerning declared preferences, (meaning either continuing the correction path for other indexes, or a rebound), investors begin evaluating monetary policy adjustments. They all know the Federal Reserve dual mandate as well as the Taylor Rule. The question is how the Federal Reserve would react to the market preferences based on other leading economic indicators. Will the Fed accommodate? Or will the Fed tighten? As of the first week of February, all events suggest that the Federal Reserve Bank will most likely tighten to offset and counterbalance the recent tax cut incentives and its corresponding spillovers.

“Core” inflation might be reflecting pressures solely generated by retailers.

Data on both unemployment and prices have monetary policy analysts wondering whether or not the US supply side of the economy is heading towards overheating. Thus far, indicators on industrial production and capacity utilization show there is still room for the economy to advance at a good pace without risking too many resources. Such indicators are produced and tracked by the monetary authority of the nation, so they have particular relevance for every analysis. However, there still are data on both unemployment and prices to help out with the diagnosis of the actual economic situation. On one hand, 92% of the metropolitan areas in the nation experienced lower unemployment rates in July 2015 than a year earlier, while only 20 metro areas showed higher rates. On the other, measure of the “core” inflation, which isolates energy and foods price volatility, reaches 1.8 percent change from the first quarter of 2015.

So, if higher production leads to lower unemployment, and the latter in turn leads to higher prices, then the easiest way to identify whether or not an economy is overheating is by analyzing to what extent prices changes are pushed up by falling rates of unemployment. This far of 2015, both conditions are met apparently. Unemployment rates are indeed falling; therefore, it could mean production is moving up. Then, what is a stake currently is to clarify whether or not US production is exceeding its capacity. Again, by looking at capacity indexes, it seems not to be the case right now. But, it is better to make sure it is not happening and thereby ruling out any alternative possibility.

Many econometric methods will help analysts to achieve valuable conclusions.

Perhaps digging into the price setting relation through regressing real wages on profits may yield some clues about the current situation. However, econometric models would severely hide the actual magnitude of oil and energy price volatility. Therefore, a rather quicker alternative lives in qualitative data. In other words, if analysts would like to know whether or not companies would transfer increasing labor costs onto the customers via price increase, what would the answers be? Econometricus.com looked at one of the state-level surveys in which such a question was included. The Texas Manufacturing Survey, which is conducted by the Dallas Fed, inquired among 114 Texas manufactures the following question. “If the labor costs are increasing, are you passing the costs on to customers in the way of price increases?” The survey answers were collected on August 18th through the 26th.

Here is what the study showed.

By sectors, surveyed retailers appear be the only ones prompted to transfer increasing labor costs to customers via price increase. Although very tight, 43.9 percent of the answers indicated that retailers would rise price as an outcome of increasing labor costs, whereas 41.5 would not. The Texas service sector respondents indicated that they would not do so by 54.5. Likewise, manufacturers rejected the possibility by 52.4 percent and considered positively by 35.7 percent. Below are the charts of which all used Texas Manufacturing Survey Data.

Texas Manufacturing Survey. Dallas Fed Aug. 2015.

Texas Manufacturing Survey. Dallas Fed Aug. 2015.

Although it is not feasible to extrapolate survey’s results onto the entire US economy, Texas’ has a particular significance for any current economic analysis. Indeed, Texas’ economy comprises a large share of oil related business, which is precisely the industry that brought this puzzle in the first place. Thus, it seems somewhat clear to conclude that following the Dallas survey, the economy might not be overheating currently.

Texas Manufacturing Survey. Dallas Fed Aug. 2015.

Texas Manufacturing Survey. Dallas Fed Aug. 2015.

So, what does these data tell economists about the US economy?

Although some would answer it says little because of its sample size and geographic limits, and its business size aggregation, there are some hints within the survey. First, it could be said that companies are currently absorbing the cost of growing, which might indicate that they are indeed venturing and the economy is expanding. So far so good. The concerns, though, stem from the speed of such expansion, which is hard to identify by using these data. But again, it is important to check Federal Reserve Data on industrial production and capacity utilization, which would yield some confidence against overheating. Second, although business size matters for determining whether or not increasing labor costs can be transferred to the customer via prices, the fact that retailers stand out in the survey must mean something for analysts. According to these data, retail appears to be the most sensitive sector right now; therefore, the 1.8 “core” inflation might be reflecting inflationary pressures solely generated by retailers.

Texas Manufacturing Survey. Dallas Fed Aug. 2015.

Texas Manufacturing Survey. Dallas Fed Aug. 2015.

Texas Manufacturing Survey. Dallas Fed Aug. 2015.

Texas Manufacturing Survey. Dallas Fed Aug. 2015.

Note:

The Dallas Fed conducts the Texas Manufacturing Outlook Survey monthly to obtain a timely assessment of the state’s factory activity. Data were collected Aug. 18–26, and 114 Texas manufacturers responded to the survey. Firms are asked whether output, employment, orders, prices and other indicators increased, decreased or remained unchanged over the previous month.

 

 

“Core” inflation rate will have huge influence on monetary policy next month.

Second Estimates for real GDP growth in the United States indicate that the economy grew at 3.7 percent during the second quarter of 2015 after correcting by price change. The report from the Bureau of Economic Analysis informs that the change mainly derived from positive contribution of consumer spending, exports, and spending of state and local governments. These increases are said to have been offset by a deceleration in private inventory investment, federal government investment, and residential fixed investment. The revised figure for first quarter of 2015 went up from -0.7 percent to 0.6 percent.

Besides real GDP calculations stand the estimates for prices changes in goods and purchases made by American residents that the Bureau of Economic Analysis (BEA) does simultaneously to the calculations made by the Bureau of Labor Statistics (BLS). In this regard, this time around the second quarter, prices had a positive growth of roughly 1.6 percent, which the BEA reports was derived from an increase in both consumer prices, and prices paid by local and state governments. Please bear in mind that, in the first quarter of 2015, prices were said to have dragged down the GDP numbers since the index decreased by roughly 1.1 percent change.

H&M Store in Broadway NYC. By Catherine De Las Salas. Summer 2015.

H&M Store in Broadway NYC. By Catherine De Las Salas. Summer 2015.

These price changes are actually good news for the Federal Reserve System for whom a moderate upswing in inflation helps them to achieve their yearly monetary goal of 2.0 percent inflation rate. And for those of whom like to make economic forecast, these figures mount onto their analysis for determining whether or not the Federal Reserve will increase interest rates in September. So, although real GDP measures are certainly corrected for price changes, the BEA’s price index will -on its own- have huge influence on monetary policy options for the months to come.

Thus, relevant data nowadays stem from BEA’s “core” inflation rate, which is to say price change without food prices and energy prices. Indeed, when figures isolate energy and foods volatility, the measure of inflation reaches 1.8 percent change from the first quarter of 2015. These changes in prices and output rightly affect the wallet of American residents. Price changes, plus increases in output -which reflect decreases in unemployment rate- may take consumer and producers to edge up their spending, which was one of the factor behind positive change in real GDP growth as mentioned above. Then, whenever spending tends to accelerate beyond its capacity the Federal Reserve reacts with an increase in interests rates. Even though one could argue that such is not currently the case, given that data on capacity utilization clearly shows that the American Economy has room to further spending, the BEA’s “core” inflation will be the measure that could possible make Federal Reserve Officials think twice about interest rates.

So, the puzzle about what the Federal Reserve will end up doing next Federal Open Market Committee meeting is fourfold, and it will derive from the different sources of data: first, price change data from BEA, which BEA claims to be way more “accurate” than BLS’. GDP growth from BEA, which is calculated by correcting price changes with their own price index. Price change from BLS, which may vary from BEA’s calculations. And capacity utilization from the Federal Reserve, which is whom finally decides on interest rates changes.

What could you infer from 06/17/15 Federal Open Market Committee decision?

What can we infer from today’s Federal Open Market Committee decision?

Today’s Federal Open Market Committee (FOMC) decision corresponds to Fed’s previous statements about the current state of U.S. economy. First, data inputs on Capacity Utilization led timidly FOMC to insights on industry output gap. Second, the Beige Book clearly illuminated onto issues related to the economic geography of current economic conditions. Third, preliminary data on GDP 2015Q1 continued to be obviously a major concern. Finally, neither was employment at stake this time, nor inflation, nor household consumption. First, In spite of the Beige Book reveling regionally based concerns, they believe nothing can be fixed institutionally. The FOMC left unchanged interest rates for federal funds, which is the rate they use to influence market loan rates. Its statement of June 17th 2015 reads “To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate”.

On one hand, Oil Prices favor certain policy pressures mostly coming from Texas; therefore, policy preference coming from related industries such as transportation and utilities. On the other hand, other type of monetary policy preferences are coming from the most recent levels of exchange rates of U.S. dollar vis-à-vis Euro dollar. Here though, the FOMC has a muscle through influencing the rate. However, doubts are cast given the uneven reality of foreign exchange rates. Thus, not modifying the interest rate –in absents of the lowering option- seems the only way for the FOMC to bolster U.S. exports thereby doing so to employment. These two economic aspects made up the current concerns of Fed’s officials. Nonetheless, neither of them could be effectively influenced under the dual mandate of the FOMC. They demonstrated today liquidity trap keeps restraining monetary policy options.

What seems to be clear after today’s FOMC statement is that although the U.S. Federal Reserve aims at closing the output gap by influencing the interest rate, the institution has no clear diagnostic on Capacity Utilization. Apparently, Fed’s officials know data on Capacity Utilization no longer unveil facts worth concluding on output gap. What FOMC probably learned on Capacity Utilization during the second week of June is that Industrial Capacity on Manufacturing is below its long term average only 1.6 percent. The Federal Reserve Index for Manufacturing Industrial Capacity is at 77 percent. Non-durable goods Industrial Utilization Capacity is just 1.5 percent below its long term average. The latter Index showed 79.1 percent. Mining Industry Capacity Index shows the sector is adjusting to oil price rapidly and registered 83.3 percent Utilization.

Finally, trying to predict what the FOMC would do regarding the interest rate seems to be more complicated task than just plugging in policy targets on the Taylor Rule equation. Actually, the Taylor Rule is nothing but a crystal bowl inasmuch as economists look at it in isolation of surrounding data and information. Indeed, they seem to seriously consider broader sources of data and make a judgement comprehensively.