Saturday, May 20, 2006

Positive Feedback

Having established in my previous post (not to everyone’s satisfaction, I realize) that Bernanke is actually a hawk, let me now turn my attention to how the Man with the Helicopter should react to the latest inflation report. If you follow the news at all, you will recall that Wall Street reacted with great dismay to Tuesday’s report of a greater than expected increase in the Consumer Price Index. Ostensibly, the reason for the dismay was the expectation that more monetary tightening would be necessary to combat the newly revealed inflation.

Let’s take a closer look. It wasn’t the large increase in the energy component of the CPI that troubled Wall Street: this wasn’t a surprise to anyone who drives. What troubled Wall Street was the unexpected increase in service prices. But in fact, there was no broad increase in service prices. The CPI for services excluding rent of shelter has risen by 0.0% over the past 3 months – hardly the stuff inflationary spirals are made of. The whole problem was with rent (especially “owner’s equivalent rent” for homeowners)..

Housing costs are important, and we certainly shouldn’t ignore them when evaluating the overall inflation situation, but we have to consider today’s rent increases in the context of recent experience. We need to consider the reasons that rents are increasing and the dynamics of any Fed response.

A few years ago, when interest rates were very low, renters began to find it economical to buy houses of their own, demand for rental housing went down, and rents – which might otherwise have risen – were kept in check. That dynamic helped keep the overall inflation rate extremely low. Today, the opposite dynamic is taking place: interest rates are higher, homeownership is uneconomical, rental demand is up, and rents are rising, contributing positively to the overall inflation rate. When you smooth out these cyclical fluctuations, though, the trend rate of increase in rents is neither dramatically high nor dramatically low. We can anticipate that interest rates will eventually reach a peak, housing markets will eventually stabilize, and rents will eventually settle into some equilibrium growth rate not too far from their historical trend.

But what will happen if the Fed responds to rising rents by raising interest rates? The answer is pretty clear: interest rates go up, so rents go up, so interest rates go up, so rents go up, and so on. (Arguably, this is, in reverse, part of what happened on the way down.) Eventually, interest rate increases will deflate the rest of the economy and put an end to the vicious circle, but at the cost of an unnecessary slowdown. If the Fed has a policy of responding to rent increases with interest rate increases, that is a positive feedback mechanism that will tend to amplify the business cycle. Of course, part of the Fed’s job is to dampen, rather than amplify, the business cycle.

So, as a first cut, the answer to how Bernanke should react to the inflation report is that he should ignore it. Unfortunately, he can’t ignore Wall Street’s reaction. The spread between TIPS yields and nominal bond yields indicates increased inflation expectations, and, as a new Fed chairman, Bernanke cannot be seen making excuses not to raise interest rates – even if they later turn out to have been good excuses. On the other hand, with the stock market down, there is more reason to worry about a weakening economy, so perhaps this offsets concerns about credibility. All in all, it’s hard to say what Bernanke should do, but in any case, Wall Street’s reaction seems a bit excessive.

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23 Comments:

Anonymous mvpy said...

Knzn,
Frankly, Im still shocked -shocked!- by your previous entry. Suggesting that Bernanke ought to engineer some deflation and then merrily have a helicopter drop then to clean things up. Huh. (Also, have you not heard of Tobins greasing the wheels theory; deflation raises real wages and causes mass unemployment. Buck up, knzn. Buck up. It seems, again, you are living in a room with no windows.)

Now, on to this current piece.

"A few years ago, when interest rates were very low, renters began to find it economical to buy houses of their own, demand for rental housing went down, and rents – which might otherwise have risen – were kept in check."

Well, no. Have you heard of the house price bubble? Many people, I gather, were simply unable to afford a new home. I live in the Bay Area, knzn. I certainly didnt find homes more "affordable". Far from it. You are conveying the impression that people just went out and bought homes as opposed to renting. This would lead to higher prices and lower rents. True. But I dont think this story is right. At all.

Couldnt you also say; well, if house prices a now stalling, more will enter to purchase, so therell be lower demand for rentals.


Is there really a positive correlation between rents and interest rates? You base your story on this. But Im not sure if this is a stylized fact, as you suggest. In the last five years or so, we had a dramatic fall in interest rates and this a gradual rise. In my area, rental prices were pretty static. More fundamentally, is there a relationship between rents and house prices?


"the stock market down, there is more reason to worry about a weakening economy,"

Didnt Paul Samuelson famously say that the stock mkt predicted 9 or the last 4 recessions. Or something like that.

"All in all, it’s hard to say what Bernanke should do"

Talk about an anti-climax, knzn.

Sat May 20, 09:40:00 PM EDT  
Blogger knzn said...

There is no question that, as a national average, costs of homeownership fell dramatically between 2001 and 2003. (The Bay Area is not typical.) Even those who believe that house prices are in a bubble acknowledge that the bubble was set in motion by falling interest rates and that it is being punctured by rising interest rates. The flip-side of the “bubble” was reduced demand for rental housing, and the flip-side of the puncturing of the “bubble” is increased demand for rental housing.

I don’t know whether there is a longer historical correlation between interest rates and housing prices, but it is at least theoretically sound: higher interest rates raise the cost of capital (e.g. houses), which makes capital services (e.g. rent) more expensive. This is a ceteris paribus argument, though. Obviously rising interest rates can also cause recessions, which reduce incomes and thus reduce demand for rental housing, so I wouldn’t necessarily expect to find a simple correlation, but that doesn’t invalidate the positive feedback argument.

Sun May 21, 10:11:00 AM EDT  
Anonymous mvpy said...

knzn,

Well. Im not convinced. At all. But bubble has been gestating for about a decade; its not something recent. Also, you cant just glibly dismiss San Francisco, Boston, etc and these large metrolpolitan areas.

If the bubble is punctured, there might be lots of latent demand; people might have held off and go and buy now. And so, reduce the demand for rentals. Suppose house prices here fall; then I might go and buy a house, whichd reduce rentals. So whatta bout this feedback effect.

Also, your argument hinges on the view that, when interest rates rise, then rental demand goes up. Okay. But, this is contingent on people moving deciding not to buy and, instead, renting. But Im thinking that many decide not to buy and REMAIN on in their initial (possibly smaller) dwelling etc. The choice is not necessarily from rentals to homes; to repeat, it could be just from homes to other homes. Which means, rentals are unaffected.

More important if you positive feedback theory is right, then the FED would surely know about it and discount that possibility.

Sun May 21, 08:02:00 PM EDT  
Blogger knzn said...

“If the bubble is punctured, there might be lots of latent demand; people might have held off and go and buy now.” Of course there are some people who are more price-sensitive than others, but with respect to the overall market, the “bubble” is clearly a demand-side phenomenon. You’re saying that the demand curve shifts down (“the bubble is punctured”).but quantity demanded goes up. I’m quite sure the supply curve for houses slopes up.

I’m not glibly dismissing large metropolitan areas in general, but San Francisco specifically is the most extreme point on the chart.

Mostly, the relevant decision is from renters considering whether to buy. (I doubt people often go the other direction.) When interest rates rise, ceteris paribus, the flow from rental into buying falls.

I expect that the Fed does consider the possibility of positive feedback, which is part of the reason that Wall Street’s reaction was excessive.

I’m still puzzled by the first paragraph of your first comment. I don’t know if you’re misunderstanding my earlier post or deliberately distorting it. The meaning of the possible allusion to Casablanca completely escapes me. Of course I don’t think Bernanke should engineer deflation or even that he will. (I think I’m one of the few people who still advocate the “greasing the wheels” theory – which contradicts the vertical LRPC seen in today’s textbooks.) But monetary policy is highly uncertain, and I’m just arguing that Bernanke will be less afraid of deflation than someone else might be.

Mon May 22, 12:02:00 AM EDT  
Blogger TStockmann said...

Unless we want to define inflation solely as what's measured by the CPI as currently calculated, it would be worthwhile to consider the effect on the actual owner-occupied housing costs that constitute 80% of the market, as opposed to owner-equivalent rent.

There is one clearcut example of positive feedback: current owners with variable rate mortgages. If interest rates go up in response to owner-equivalent rent measurements, their cost of housing increases. If this were being measured in the CPI, the feedback mechanism would be both positive and direct, irrespective of demand-condition changes resulting from interest rates. In the case of current owners with fixed mortgage rates, there would be much milder negative feedback on housing costs because the higher interest rates restrain price increases, thereby limiting growth in property taxes. This presumes a static model where the owners are not attempting to trade properties, which is a subset of new purchasers.

For new purchasers, a relatively small minority of those incurring housing costs, whether the feedback on higher interest rates is positive or negative depends on the ratio of purchase price (presumably decreased) and the higher interest rate. Housing nationwide was growing less affordable since 2003 even before the relatively recent interest rate increases, but real estate prices are notoriously "sticky" rather than a predictably transparent before total costs.

Finally, then, to consider the owner equivalent rent portion of the CPI. Demand for rental units would increase as the total cost for owning a new house increased, which is knzn's positive feedback on the cpi. Demand for rental housing would further increase if the expectation of the appreciation in the value of owned property vanished. However, I can't even begin to predict what would happen if property depreciated substantially enough in real terms to more than offset the increase in interest costs. There's also a matter of supply. If we are just past the peak of the business cycle for housing, this would argue for a gross oversupply of housing units, and since there is a substantial fungibility between owner and rental units and a substantial time-lag in producing these units, the collapse of market expectations for sale could produce units for rental consumption far above the additional demand generated, providing the countercyclical check on inflation desired. Remember that total housing demand - leaving aside things like vacation units - is relatively inelastic.

Mon May 22, 12:41:00 AM EDT  
Blogger knzn said...

“If we are just past the peak of the business cycle for housing, this would argue for a gross oversupply of housing units…providing the countercyclical check on inflation desired.” This is, it seems to me, another example of positive feedback, but with a longer lag. The reason for the oversupply is that interest rates were low for so long, making it cheaper to build houses and (more important) leading to the temporarily high demand for OO housing that some characterize as a bubble. If the Fed had waited longer to raise interest rates, the oversupply would have been even larger. As it is, it looks like the result may turn out to be countercyclical, but that’s more “the luck of the lags” than any kind of foreseeable policy result.

I’m not sure that the feedback to actual (as opposed to measured) ownership costs is of much importance. The Fed should (and, I think, does) try to filter out these temporary effects and focus on longer-term inflation. But that task becomes difficult when there are ugly numbers coming out.

Mon May 22, 10:16:00 AM EDT  
Anonymous mvpy said...

"Mostly, the relevant decision is from renters considering whether to buy. (I doubt people often go the other direction."

Well. With a bubble, investors are a big part of the story; property developers and all that. I think you are overemphasizing the renters thing.

"San Francisco specifically is the most extreme point on the chart."

Boston, San Diego, NY, etc etc.

"I’m quite sure the supply curve for houses slopes up".

Wrong. In the short run, its inelastically supplied. In a bubble supply could slope up. High prices might reduce supply since people expect them to rise further etc. Ok, that sounds a bit c-r-a-z-y.

I think the other commentator said this, In not sure. Suppose theres lots of homes built during the bubble. Then the FED raises rates, right? You are saying rents go way up. But thered have been more supply initiated in the first instance (supply curves); if people couldnt afford them, theyd be now rented out by contstuctors.

Oh, knzn, Im assuming homes have windows; apparently, unlike the ones you live in.

Mon May 22, 11:45:00 AM EDT  
Anonymous Anonymous said...

As a real estate broker/investor knzn is on target with the windows wide open.


Rents will increase if the current falloff in desirability of purchasing continues. Desireability is being restricted by rising interest rates, stagnent wages and a lack of bodies leading to stagnent/falling home values.

Minimum wage legislation, immigration policy, an Iranian war are three fiscal policies that could have a profound impact on monetary policy.

Since this is an election year, guessing whether the Fed uses its inverted yield curve club is hazardous.

My guess is rents (and CPI) will increase with wages along with increases in lt interest rates as the Fed pauses, resteepening the yield curve.

Tue May 23, 02:08:00 PM EDT  
Anonymous mvpy said...

knzn,

Where are you, young man. Are you in the long run or something?

Here I am all day, everyday waiting for a new post.....

Perhaps youre flying round the country again watching RAN. The possibilities are endless; the mind boggles....

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