House of pain: Jumped up to get down?
Back
Article Type
Insights
Topic
Macro
Published
January 26, 2024
Read time
6 mins
Authors
Sean Fanning, CFA
Tom Zorawski, PhD
PDF
Download
Share

  • The impact of restrictive monetary policy pain in moderating demand and slowing growth is still in progress as cyclical inflation continues to fall.

  • A key question will be on the speed of pain relief.

  • This paper supports Aegon Asset Managements base case view of a growth recession in 2024.1

 

Many market participants seem to have interpreted Chairman Powells comments at the December Federal Open Markets Committee (FOMC) meeting as signaling that the Fed believes it is on the verge of stamping out inflation. However, recently released minutes from that meeting seem to indicate FOMC members are making a finer distinction, looking at the progress that has been made in each of two different processes:

 

"Several participants assessed that healing in supply chains and labor supply was largely complete, and therefore that continued progress in reducing inflation may need to come mainly from further softening in product and labor demand, with restrictive monetary policy continuing to play a central role."2

 

This softening in demand and slowing of growth is the pain that the economy must bear in order for inflation to return to the Feds 2% target for a sustained period of time. And these words from the minutes in fact echo the view that Powell presented at the November FOMC meeting, before his “tidal shift”1 at the December FOMC meeting. At that November meeting, Powell outlined the same two processes, concluding that the unwinding of the distortions to both supply and demand from the pandemic can bring down inflation without the need for higher unemployment or slower growth, supply-side improvements I think those things will run their course, and well still be left with some ground to cover to get back to full price stability.3

 

Inflation: Acyclical and cyclical components

 

These two processes can be approximately mapped to the acyclical and cyclical components of inflation in the San Francisco Feds attribution of core PCE4 shown in Exhibit 1. The acyclical component, which has reverted close to the historical average, tends to be more sensitive to industry-specific factors, such as the unwinding of pandemic supply distortions. The cyclical component, which remains elevated, tends to be more sensitive to overall economic conditions and, as a result, to monetary policy. The restrictive monetary policy components pain on moderating demand and slowing growth still has a distance to go, which supports Aegon Asset Managements base case call of a growth recession in 2024.

 

Exhibit 1: Acyclical and cyclical core PCE inflation (year over year)

 

Exhibit 1: Acyclical and cyclical core PCE inflation (year over year)

 

Source: Federal Reserve Bank of San Francisco, Aegon Asset Management. As of November 2023.

 

The housing factor

 

A key driver of the cyclical component of core PCE is housing inflation,5 so getting a sense of the future behavior of this component can provide insight into how long it might take cyclical inflation to come down. Our focus will be on owners equivalent rent (OER) since it makes up the vast majority of housing inflation.6

 

Using the same inflation rent microdata as the Bureau of Labor Statistics (BLS), the Cleveland Fed7 created a New Tenant Repeat Rent (NTRR) index that isolates the rent growth for new tenants. It determined that the difference between prominent rent growth indices and BLS rent inflation is almost entirely explained by the differences in rent growth for new tenants relative to the average rent growth for all tenants. Their research also showed that the growth rate of the NTRR index historically leads the growth rate of the overall rental index as the all rent index catches up to the new rent values when leases roll over. Exhibit 2 shows the current difference in level between the average rent price and the new rent price.

 

Exhibit 2: Level difference: New rent versus all rent (consumer price index owners equivalent rent)

 

Exhibit 2: Level difference: New rent versus all rent (consumer price index owners equivalent rent)

 

Source: Cleveland Federal Reserve; Bureau of Labor Statistics. As of December 2023.

 

To get a feel for how long it will take for this process to play out, we produce a forecast for housing inflation that is a combination of two effective approaches recently appearing in the literature. The first relies on the link between the levels of the new rent and all rent indices discussed above, which carries over to market rents and housing inflation in general.8 This provides us with a key predictive variable. The other candidate variables come from the known lead in the growth rates of market rents relative to housing inflation alluded to above. We select the best variables and weight them using an elastic net technique.9 Exhibit 3 illustrates both a historical back test and our forecast for the evolution over the next year. As mentioned previously, we forecast only the OER component, since it makes up the vast majority of housing inflation. The back test is at the one-year horizon (i.e., using only data available from one year prior) and tracks actual OER very closely.

 

Exhibit 3: Owners equivalent rate forecasts: Back testing and predictions for 2024

 

Exhibit 3: Owners equivalent rate forecasts: Back testing and predictions for 2024

Source: Aegon Asset Management. As of January 2024.

 

The forecast includes error bands, which are set separately at each horizon, based on the errors from the back test. Under our base case projection, shelter inflation falls slowly from the current rate of about 6.3% to only around 4.3% by November 2024. Shelter inflation jumped up abruptly in 2022, but it will likely not come down as quickly. This is because during the runup, the growth rate of market rents significantly overshot the housing inflation rate, leading to a large gap between the index levels. Although the deceleration in market rents will feed through to the inflation rate, there is an opposing force10 pushing the inflation index to catch up to the level of rents, which should slow down the process.

 

The nature of the pain

 

One of the key questions in 2024 will be the pace of and reason for Fed interest-rate cuts. There is a distinction between the Fed being able to reduce rates slowly back to a neutral level or whether the Fed is forced to cut rates rapidly past the neutral level. Can cyclical inflation come down fast enough on a sustained basis to allow policymakers to remove monetary restrictions and blunt the impact of their past tightening to ease the "pain"?

 

In the discussion above, we looked at housing as a driver of inflation, which is an input into Fed policy. We can also use it as an illustration of the roll over dynamics in the markets for a given policy setting. By this we mean a situation where a change in the price level gradually works its way into the economy as only a fraction of participants must adjust to it at any particular time. As we have shown, it is not just the change in current market pricing but the difference in level between the average and the current that impacts the cyclical portion of the economy. The starting point matters.

 

The lag in housing inflation is similar to the process of an issuers coupon payment (all rents) converging toward current market yields (new rents) as debt rolls over. The process takes time. Now, since there remains a difference in level, even if new rents were to come down slowly, we would expect all rents to continue to increase as leases roll over. Similarly, if the Fed were to cut rates slowly, then we would expect the average coupon of issuers to increase as the new issue yield is above the average coupon rates. In other words, there is more impact to come, and this means that a growth recession is a likely outcome.

 

Revisiting the final act

 

Related to the speed of rate cuts is the question of when they will begin. The Aegon Asset Management base case view is for rate cuts to begin in July, later than the March start date implied by the market. As support refer back to the three-component framework we detailed in The Right Choice of “Beveridge” for the US’s Final Act of Inflation, which served as a reliable indicator that there would be no rate cuts in 2023. Since this piece was published, year-over-year growth in core services ex housing PCE inflation has dropped from around 4.9% in December 2022 to about 3.5% in November 2023. However, this is still above the level consistent with the Fed’s target, as is the 3-month annualized run rate of 3.0%. Although headed in the right direction, the Fed will likely want to see Act III draw nearer to a positive resolution before flipping into rate-cutting mode.

 

1"2024 US Macro Outlook: The (Fed's) tidal shift."  Aegon Asset Management, January 2024

2“Minutes of the Federal Open Market Committee, December 12-13, 2023.” Federal Reserve Board. 

3“Transcript of Chair Powell’s Press Conference November 1, 2023.” Federal Reserve Board.

4“Indicators and Data: Cyclical and Acyclical Core PCE Inflation.” Federal Reserve Bank of San Francisco.

5Zaman, Saeed. 2019. “Cyclical versus Acyclical Inflation: A Deeper Dive.” Federal Reserve Bank of Cleveland, Economic Commentary 2019-13.

6OER makes up approximately 74% of CPI housing (aka shelter) inflation with rent of primary residence comprising approximately 22% and hotels approximately 4% as of December 23, 2023. PCE uses the same underlying OER and rent of primary residence series as CPI.

7Adams, Brian, Lara P. Loewenstein, Hugh Montag, and Randal J. Verbrugge. 2022. "Disentangling Rent Index Differences: Data, Methods, and Scope." Working Paper No. 22-38. Federal Reserve Bank of Cleveland.

8Technically speaking, we make use of an “error correction” term. This simply means that as these two indices generally aim to measure the same quantity—the price of housing—their levels should equalize over time. For more detail, see: Atkinson, Tyler. 2023. “Rent inflation remains on track to slow over the coming year.” Federal Reserve Bank of Dallas. 

9For details on the specific application to housing inflation, see: Marijn Bolhuis, Judd Cramer, and Lawrence Summers. “The Coming Rise in Residential Inflation.” NBER Working Paper No. 29795.

10See footnote 8 for the technical description.

Important disclosures

Authors

Sean Fanning, CFA
Senior Portfolio Manager
Sean Fanning, CFA, is a senior portfolio manager on the US public structured team specializing in CLOs and ABS.  
View profile
Tom Zorawski, PhD
Senior Quantitative Research Analyst
Tom Zorawski, PhD, is a senior quantitative research analyst on the quantitative solutions team responsible for implementing new techniques in the areas of macro forecasting, systematic credit, and asset allocation to support the firm's investment process.
View profile
Related Articles
View all Aegon insights