Matt Boesler posted an interesting chart today showing a leading relationship between house price appreciation & OER. Expounding on this idea & data set results in some interest conclusions about the likely trajectory of core inflation in the US.
Housing, technically shelter, is the largest component of core CPI, with a 42% weight in the basket. Shelter is decomposed into primary residence rent and owners' equivalent rent (to have a smooth proxy for housing prices). OER & housing prices have seen material divergences since the Case-Shiller 20 index began being published in 2000. However, a closer look shows a strong lead-lag relationship between the % YoY changes in OER vs Case-Shiller, with some data fitting leading to 21 months as a useful time lead. Linear & polynomial (3-degree) regressions with this time lead are presented below.
Using this regression analysis to model % YoY OER, and linearly standardizing the modeled OER (to account for much wider range of % YoY rates in housing prices vs rents), a rough but useful projection of future OER, and consequently housing price inflation, is in the pipeline based on the leading indicator of housing price growth. With this, we constructed a projection for housing's net contribution to core CPI % YoY, which is presented below.
Based on current housing prices, the model suggests that housing alone will provide 100-140 gross basis points to core CPI YoY growth rates by H2 2015, or 50-70% of the way to target inflation. This includes an approximately 40bps increase in net bps contribution to core CPI YoY, in the next 21 months, implying that even if non-shelter core inflation rates stagnate at their current 0.46% YoY rates--all the way through 2015--core inflation will still return to Fed target. If non-shelter core inflation rates can simply reverse solely their 2013 deceleration, over the course of the next 21 months, the implied core inflation rate would be just under 3%, and 1yr fwd inflation expectations (the FOMC FG criterion relevant to rate policy) would likely have breached the FOMC's 2.5% symmetrical target ceiling. These scenarios serve to illustrate how impactful the extra 40bps net housing contribution to CPI can be.
Looking beyond housing, there are good reasons to believe that non-shelter inflation is poised to accelerate materially and be the driving force behind overall inflation acceleration:
- Less policy uncertainty & drag. Fiscal cliff and fiscal policy uncertainties, which pervaded in 2011-2013, were huge drags of federal & corporate spending, as well as crushed money supply growth despite open-ended LSAPs. These policy concerns materially diminish this year, and as should their sharply deflationary impulse.
- Private sector accelerating behind the scenes. Real private wages are accelerating impressively, and the sharp disinflation phase since 2011 has been fundamentally tied to a private-public divergence on the back of austerity (public wage growth has hovered around zero since H2 2011 post-debt ceiling debacle).
- Supply & demand of fixed capital seeing trend shifts. H2 of last year was the first time since the GFC that US net private domestic investment went positive. Capacity has been expunged and now a combination of nascent short-term demographic tailwinds and low capacity & costs means fixed investment is likely set to return. Supply & demand of fixed capital is what drives prices fundamentally.
- High-velocity credit growth & capital spending is beginning to accelerate. Leading indicators for capex (which should also see a positive impulse from fiscal policy stability) are picking up for the first time since 2011, and other high-multiplier entities that have been risk-averse since 2008 (like state & local governments) are beginning to spend again after healing their balance sheets. C&I loans and consumer credit demand also heating up.
- Producer prices & input costs are accelerating. Pipeline inflation.
Vince Foster had a terrific piece over the weekend analyzing the recent behavior of long-term yields. Although I share his concerns about long-term NGDP potential growth rates for the US (absent immigration boom, public infrastructure investment, etc), especially regarding the question of not being able to escape ZIRP again in next recession, I think that US core inflation is set up for cyclical acceleration. I expect to write soon about some of Vince's arguments, as well as some of the near-term risks I see in the global economy.