The Fed Will Ease for a Long Time

Today, I’ll examine the impact which the housing market has on the CPI index, and conclude that there is a delayed reaction (like a few years), before lower housing prices impacts the CPI. Based on the data I present, it suggests to me that the CPI index will have a hard time getting above 1%, regardless of what the Fed does, based on the current level of home prices. Accordingly, I expect the Fed to be engaging in money printing and other, to be announced, easing strategies, for years to come.


* If you have been following my blog for the last few months, then you know that I believe we entered a depression in 2008, which still has many more years to run. I left you off yesterday with the idea that the Fed is desperately trying to inflate the economy so it does not sink into round two of the Great Depression 2. A closer look at the inflation data which the Fed is focusing on brings us to the CPI index, of which 42% is dedicated to housing. Over the last 12 months, CPI rose 1.1%, while CPI-housing fell 0.3%, and ex-housing, CPI rose 2.15%. If the Fed is complaining about the price index not rising fast enough, it is because the housing market is going through its own depression.


               CPI-Housing   Case-Shiller

(*  Sep-10       216.16        148.91

     Jan-10       215.93        145.31

     Jan-09       216.93        146.34

     Jan-08       212.34        180.68

     Jan-07       206.06        202.31

     Jan-06       200.00        202.44

     Jan-05       191.80        176.44

     Jan-04       186.30        151.69

     Jan-03       182.30        135.64

     Jan-02       177.60        120.64

     Jan-01       174.10        112.39


In the above chart, I put the Case-Shiller Index next to the change in the CPI’s Housing component. To me, the CPI Housing component is the key, especially since this comprises 42% of CPI.I also realize that non-house items goes into the housing contribution to CPI, like furniture for instance, but for now I am assuming they are all the same. A look at the changes in these indices is perhaps a bit more revealing:


              CHG CPI-Housing     CHG Case-Shiller  3 yr change in Case-Shiller

(*) Sep-10             0.1%              2.5%                      -17.58%

     Jan-10            -0.5%             -0.7%                      -28.17%

     Jan-09             2.2%            -19.0%                      -27.71%

     Jan-08             3.1%            -10.7%                        2.40%

     Jan-07             3.0%             -0.1%                       33.37%

     Jan-06             4.3%             14.7%                       49.25%

     Jan-05             3.0%             16.3%                       46.25%

     Jan-04             2.2%             11.8%                       34.97%

     Jan-03             2.6%             12.4%                       35.64%

     Jan-02             2.0%              7.3%


(*) Sep 2010 reading for CPI and July 2010 reading for Case-Shiller, and the changes represented are from Jan, 2010.



This shows that the Case Shiller index of housing prices, after rising by double digits for 4 years, went flat in 2006 (Jan 2007 data), and spent the next two years (2007 and 2008) dropping by a total of 30%. From the looks of it, there is a lag between the time that the Case Shiller House price index changes, and when CPI-Housing index actually follows. There is not enough data to run statistical tests, and determine the lags, as well as the sensitivity of CPI-Housing to actual housing prices, but let me draw a few logical conclusions, from which a model for CPI might be derived:


1> On average, only a small share of the total housing stock changes hands every year, and accordingly, the rising costs of housing will only affect those buying a new or existing home at a higher price, during any given year. 


2> Lets assume that 15% of all housing stock changes hands every year, which assumes that people move every 7 years. In years in which house prices rise 15% (Case Shiller), then this means that the CPI-Housing index should rise 2.25% (15%/7).


3> Let’s modify this assumption to assume that when someone buys a new home, their cost basis does not change by the 1 year change in home prices, but rather the cumulative effect of a 3 (arbitrarily selected) year change in home prices. In 2005 (Jan 2006 data), the 3 year change in home prices rose 49%, while the corresponding  change in CPI-Housing, was 4.3%, or about 9% of of the change in CPI- Housing.


4> However, this formula does not work so well in 2008 (Jan 2009 data), as the 3 year change in Case Shiller was down 27% while CPI-Housing was up 2.2%. It comes a bit closer in 2009 when the 3 year change in Case-Shiller was down 28% while CPI-Housing was down 0.5%.


5> One additional factor which could be over-layed into this thought process has to do with the amount of housing turnover taking place in any given year. So, in 2008 or 2009, when the financial crisis was raging, home sales numbers were down dramatically (28% from 2005 to 2008), which leaves us with the idea that fewer people were taking advantage lower housing prices, and accordingly, CPI-Housing would respond in a more sluggish fashion.


There is likely some mathematical function which accounts for how the change in home prices affects the CPI-Housing index, but as I said before, I do not have enough data to statistically determine what this formula is exactly, but it appears obvious to me that: 


1> The change in CPI-Housing is a function of the change in home prices;


2> There is a lagged effect before the change in home prices affects CPI-Housing;


3> Accordingly, I expect the cumulative drop in home prices, which has occurred since Case-Shiller peaked in 2006, to continue to have a strong downward influence on CPI-Housing over the next few years.


If the Federal Reserve has done any research along the lines which I just presented, and they have a lot more data, and staff to vet these issues, then it should be obvious to them that they are in deep trouble. What if CPI-Housing drops to the 2006 level of 200, or down 8% from current levels over the next three years. This is 42% of CPI, so in effect, this would contribute to a 1% drop in CPI for each of the next 3 years. Combined with 2.1% inflation in the other 58% of CPI, this would produce CPI rates of 0.7%. If I look at the core CPI index, less food and energy (22%), then the effect of a -1.7% change in CPI-Housing could push the CPI index closer to zero.


The Fed must see the effects which falling home prices are going to inflict on the widely reported CPI index. This is the same thing which deflationists, such as myself, have been looking at when we talk about the great de-leveraging in the US housing market. Lower housing prices do have a significant impact on the wealth of the country, and the corresponding wealth effect on the economy, but you never hear the Fed talk about this. Because if the Fed did so, then you would see them talking about buying real estate of stocks outright, which of course is not a sustainable strategy. Additionally, the Fed is not allowed to buy real estate or stocks. Instead, the Fed is backing into supporting the wealth of this nation, and the wealth effect, by attacking the sinking inflation rate. This also is more palatable, since their dual mandate is to manage the inflation rate to a level which supports economic growth.


It is surprising that it has taken this long for falling home prices to actually affect the CPI index, but now that the effects have arrived, I expect this to have a real negative impact on CPI for quite some time. Accordingly, since this is the inflation metric the Fed is going to use, (along with a chronically high unemployment rate), to justify additional easing strategy, including the favorite flavor, printing money, I expect the Fed to be easing for many years to come. Before this easing party is over, I also expect the Fed to reduce the interest rate they pay on excessbank reserves from 0.25% to 0.0%, which in turn will engineer negative short term interest rates, as I have explained in previous blogs.


* Trading Points – the entire complex of stocks, bonds, foreign currencies and precious metals have been sporting bullish consensus readings in the 90s for quite some time, and are in the process of putting in collective tops. It would not surprise me if these markets hold up until election day, or to the conclusion of the Fed meeting a day later, or, it is quite possible that these markets are in the process of falling right now. Here are some support levels I am looking at with respect to these markets:


Stocks (S&P):          1150-1155             (now at 1170)

The Euro:              137.50 & 135.80       (now at 138.10)

Gold:                  1320-1325             (now at 1340)


As you can see, gold and the euro are close to breaching this downside support zone, but in my opinion it will not be a horse race to the downside until all three of the markets are moving together, and have breached their downside support levels. Once these markets start to move, there should be plenty of downside below these levels, so for my two cents, I will wait for this turn-arounds to be confirmed by a break of these levels.