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.