FORTUNE — “If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished, and without utilities?”
Believe it or not, the government asks ordinary American homeowners that perfectly imprecise and highly subjective question every single month as part of the Bureau of Labor Statistic’s monthly price survey process. The answers determine the calculation of “Owner’s Equivalent Rent,” which represents almost 25% of the index used to calculate consumer price index inflation in the United States.
It is, quite possibly, the most absurd way to calculate inflation.
The answers have a profound effect on U.S. monetary policy and influence how much you ultimately pay for groceries, gasoline, and much more. If you answered that question in the last month or so, your response appeared in the latest Consumer Price Index report and influenced Fed Chair Janet Yellen’s debut speech.
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The head-scratching bottom line? Pie-in-the-sky guesses of homeowners, overwhelmingly lacking both economic training and policy experience, are the tail wagging the Federal Open Market Committee dog.
Over the years, the way the government calculates inflation has been repeatedly reformulated with a general impact of consistently lowering headline inflation readings. This benefits the government’s checkbook by lowering inflation-tied payments such as Social Security and TIPS inflation-adjusted bond payments. It also lowers the cost of new borrowing, making it cheaper to roll over Treasury issues.
But it harms American consumers.
Have you been to the grocery store lately? The prices of coffee, cheese, and pork are up double-digits in just the last six months. Americans are paying 30% more for breakfast than on January 1st — and still getting a negative real return on their savings.
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The Shelter component, including the outsize Owner Equivalent Rents piece, represents about one-third of CPI, and this measure has diverged from all other components. By last month, Shelter flashed over 2% inflation, but the combined non-shelter component was tracking at just 0.5%. CPI inflation is making the Fed look shaky as it relies on a one-trick-pony to assess the health of the economy.
As modest inflationary pressures continue across the largest part of the economy, the acceleration in Owner Equivalent Rents has single-handedly driven growth in headline inflation. At her press conference last week, Chairman Yellen reiterated the Fed’s 2% inflation target — a disappointing 1.1%, but Yellen said the FOMC expects it to gradually track back toward their target.
Housing recovered with surprising strength from the end of 2012 into last year, but it has been decelerating. A material slowdown in home price appreciation from here would likely drag down the Shelter component, putting pressure on the CPI.
Economics is hardly an exact science (spoiler alert!) but we dare not discount the possibility of CPI ex-Shelter continuing to grow at its trailing 12-month average of 0.9% through the rest of this year, while the Shelter component could decelerate by 1%, down to 1.6% year over year. This would not be an extreme scenario — unless you are a Fed policy maker in need of another 75 basis points to justify a policy turn.
We’re not predicting anything. But with housing slowing, labor supply declining, and disinflation prevalent across the developed markets, no one should be surprised if CPI inflation languishes below 2% for the time being. Policy (and market hysteria) is based on projections. Projections tend to over-assume current scenarios; reality, when it finally gets here, tends to be less extreme. Fasten your seat belts for what may be an uneventful ride …
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Even consumer inflationary pops like pork and coffee, though highly visible, are less broadly impactful. It appears that headline inflation figures may be masking more moderate inflationary pressures in the largest part of the economy. At these levels, even a few basis points can have a material impact on policy. An inflation disappointment will likely trigger fancy rhetorical footwork to justify future monetary policy decisions.
Right on cue, the 6.5% threshold is out the window, replaced by a fuzzy basket of indicia — like asking “common folks” what they think their home would rent for. Chairman Yellen is plenty intelligent; she clearly recognizes that the Fed can’t pursue a “qualitative” focus while also claiming to be data dependent.
Bernanke’s program was to print infinite quantities of money. Now Yellen has to change the Fed’s tone as she wrangles with an out of control balance sheet, the legacy of Quantitative Easing. We’ll call the new initiative “Qualitative Easing.” Rather than the “stick” of cash, Yellen offers the “carrot” of vague, hopeful comments designed to nudge interest rates. Like a corporate management gaming their stock price, the Fed will now rely on giving the markets “guidance.”
The demise of quantitative easing marks a clear hand-off, as the Yellen Fed abandons cash in favor of using its credibility. We’re not sure what they’ll turn to when that runs out.
Christian Drake is a macro analyst at Hedgeye Risk Management. Moshe Silver is a managing director and author of Fixing a Broken Wall Street.
