In this episode of the REconomy Podcast™ from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi discuss the challenge facing the Federal Reserve in 2022 – how to tackle inflation while protecting the economic recovery – and what that means for the housing market.
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Listen to the REconomy Podcast™ Episode 29:
“The Fed clearly faces a very unique challenge in 2022. How to tame inflation without halting the recovery, and the housing market is entering 2022 with double-digit house price growth, strong underlying demand and near record-low supply. A modest increase in mortgage rates due to tighter monetary policy may actually bring some much-needed house price moderation.” – Odeta Kushi, deputy chief economist at First American
Odeta Kushi - Hello, and welcome back to another episode of the REconomy podcast, where we discuss economic issues that impact real estate, housing and affordability. I'm Odeta Kushi, deputy chief economist at First American and here with me is Mark Fleming, chief economist at First American. Hi, Mark. First of all, happy new year. It is our first episode 2022.
Mark Fleming - Hi, Odeta, Happy New Year to you too. And hopefully, it's just 2022 and not 2020 too. Get it?
Odeta Kushi - Oh, I get it. Well, I think after these last two years, we are ready to get back to some precedented times. But, you know, 2022 is still likely to present some unique economic challenges. And there is one institution in particular, which will be key in navigating those challenges. The Federal Reserve.
Mark Fleming - Duhn, Duhn, Duhhhn. I find it ironic, but also good that for our very first episode on our very first day back at work for the new year that we talk about the Federal Reserve, because I think they will play a very key role for the rest of this year for us in the housing market. So, yes, we are entering this year, with persistently high inflation and a still strong economic recovery. One of the primary reasons behind that high inflation, of course, was pent-up demand last year, along with insufficient supply due to all of the COVID-induced shortages and bottlenecks that we're still dealing with. So the Fed has the dubious challenge this year of possibly having to raise rates and temper that demand. But, that has little ability to really fix or alleviate issues on the supply side.
Odeta Kushi - So then, how does the Fed tame this inflation without killing the recovery? That's what we'll discuss in today's episode, the unique challenge facing the Fed in the year to come. And, of course, the implications for the housing market. But, first, maybe a refresher on the dual mandate of the Federal Reserve.
Mark Fleming - Dual mandate? Like the classic joke about economists, on the one hand and on the other...
Odeta Kushi - On the other.
Mark Fleming - And of course, this is so simple. No biggie, the dual mandate of the Fed is to have stable prices and maximum unemployment. That means keeping inflation in check, and keeping unemployment low. Now, neither of these goals is zero, you don't have zero unemployment, you don't have zero inflation. The inflation target is actually about 2%. And the unemployment target is to be - I'm going to be a little economic here - consistent with the economy's potential. And, of course, we can easily measure that. That's not a problem. This, quote-unquote, natural rate - if people could see me air-quoting right now - of unemployment is the rate of unemployment arising from all sources, except fluctuations in aggregate demand. And by our excellent measures is estimated to be about 4%.
Odeta Kushi - Well, we have made significant progress in the unemployment target. The unemployment rate, if you recall, actually peaked at about 15% in the spring of 2020. And, as of November 2021, it sits at about 4.2%. So, actually pretty close to that natural rate that you just mentioned. Now, does that mean that we've reached full employment? Not quite, approximately 17.5 percent of the jobs lost in the pandemic have not been regained. And there are more than 2 million workers still missing from the labor force compared with pre-pandemic levels, and their return has been pretty slow. Now, we might not regain all of the workers lost because some of those workers retired early, and they're unlikely to re-enter the labor force. But, the key point here is that the labor market recovery has made significant progress, even if we're not quite at full employment. But, what about that other mandate? Inflation?
Mark Fleming - Well, we did mention at the top of the episode that inflation was just a skosh, or more above target. Measured by the CPI, the Consumer Price Index, it reached nearly a four-decade high in November 2021 at 6.8% compared with a year ago. That was the fastest pace since 1982. And the sixth straight month in which inflation topped 5%. So, we are running pretty hot from an inflation perspective right now. The Core Price Index, you may have heard people talk about that, which excludes food and energy - we don't really need those in our daily lives - climbed about 4.9% in November compared with a year ago. That's the highest rate since 1991. So, by these measures, yes, we are well above our inflation target.
Odeta Kushi - Well, and you know, the Fed actually prefers another measure of inflation, just to make it a little bit more confusing for everyone. A personal consumption index. One of the primary differences between the PCE and the CPI is that the PCE actually takes into account consumer substitution. So, the expenditure weights in the PCE can change as people substitute away from some goods and services toward others. So, for example, the price of bread goes up and people buy less bread, the PCE takes into account that change. Now that PCE measure actually jumped nearly 6% in November, the highest since 1982. Again, removing energy and food, it increased nearly 5%, the highest since 1983. A lot of stats here, but long story short, it's above the Feds 2% target.
Mark Fleming - That's right. And let's have a little more fun and make it even a little more interesting. Did you know that in the summer of 2020, Fed Chairman Jerome Powell announced a new approach to managing that inflation target, where it's okay for inflation to run hotter than the target level in order to support the ability to create healthier labor markets if you need to get that unemployment rate even lower? The central bank formerly called this the policy of average inflation targeting. Sometimes a little above, sometimes a little below. I feel a nursery rhyme coming at some point in this podcast. That means that it would allow inflation to run moderately, as they say, above the Feds 2% target goal for some time, basically the situation that we're in now, following periods when it has run below the objective. And it's true that we have had inflation persistently below the 2% level for a number of years. This allows longer periods for the Fed to have accommodative monetary policy to help that labor market, the other hand dual mandate, to be improved before they have to tighten their monetary policy, even with inflation running above where it is. And that's really the situation we're in today at the beginning of this year.
Odeta Kushi - Right, but some things have changed mostly in language, right? Because when inflation did begin to creep up during this recovery, the Fed maintained that it was due to transitory factors, a sudden influx of demand against a limited supply caused by these supply chain disruptions, which would clear up. They have since moved away from that language. The Federal Reserve, as we know is data dependent and will change course when data emerges that indicates the economic situation is changing. As more data started coming in, that employers' spending on wages and benefits was also rising alongside the basket of goods, the Fed was concerned that inflationary pressures could be broader and longer lasting than initially expected. And that made them kind of move away from that transitory language. The Fed's policy committee then announced that it would speed up the end of the central bank's bond-buying program and was likely to raise interest rates sooner than had been envisioned. But, I mean, are there some risks here? We touched on it earlier in the episode? Could the Fed cool the economy too quickly, and maybe cause a recession?
Mark Fleming - Well, I certainly don't envy the members of the Federal Reserve that have to make these decisions, because it is certainly very tricky. Does the Fed need to provide stimulus to an economy where the consumer demand is already strong? We see that asset prices are high, house prices continue to reach record levels. That demand is definitely there. And that strength could be cooled, but the major challenges in the economy seem to be more on the supply side, which as we mentioned, is somewhere that the Fed has much less influence. But what the Fed can do is taper or raise interest rates, raising the cost of money. Theoretically, at least, that would temper demand relative to that constrained supply. But the real question, and the hardest one here, is by how much?
Odeta Kushi - Well, we do love our history. So I guess I'll ask, are there any historical examples of the actions of the Federal Reserve actually prompting a recession?
Mark Fleming - You should take note when I make this statement. Of course, this time is definitely unique. I feel like I got my one hand out here right now. But there is an example. Different circumstances potentially, but an example where the Fed was actually trying to tame double-digit inflation in the late 1970s and early 1980s by raising rates. The mortgage rate back then was at 18.1%. Inflation was running even hotter than it is now. And under Federal Reserve Chairman Paul Volcker, they really took a concerted effort and skyrocketed interest rates to nearly 20% to get inflation under control. It did eventually come down, but the side effect was a double-dip recession between 1981 and 1984.
Odeta Kushi - And this time, it's different, as you said. That's not to say that we will experience the same thing this time around. It's certainly possible for the Fed to lead the economy to kind of a Goldilocks level, if you will. A steady...
Mark Fleming - There is it is, there's the nursery rhyme.
Odeta Kushi - There's the nursery rhyme, it comes full circle. You know, a steady increase in interest rates may cool demand as supply challenges ease, so 2022 may bring some balance while not compromising the labor market recovery, but it is a very difficult needle to thread. But coming back to the core of what we do, what is all of this Fed talk have to do with the 2022 housing market?
Mark Fleming - Yes, our specialty in housing. Well, we've said this before, but it bears repeating. Because it's fundamental to the housing market, the popular 30-year, fixed-rate mortgage is loosely benchmarked to the 10-year Treasury bond yield. When global investors sense increased uncertainty, and we can clearly see that that's happened in the last couple of years, there is a flight to safety in US Treasury bonds, particularly longer bonds, like the 10-year Treasury that causes their price to go up, and their yield to go down, driving interest rates down and mortgage rates down. We've seen that in the last couple of years in our own industry space in housing. But, of course, the opposite of that is also true. When the economy is improving and there's prolonged expectations of higher inflation, bond buying slows down, which drives down the price of bonds and increases yields. And so this environment, in theory, should cause interest rates to likely rise. We've seen that a little bit at the end of last year. All expectations are that we will see increasing interest rates this year. Nobody's suggesting by a lot more, but certainly by more nonetheless.
Odeta Kushi - Well, I should mention that the housing market is so hot that an increase in mortgage rates may not be such a bad thing in the near term.
Mark Fleming - That's right. On the one hand, the supply of housing is short, and on the other hand, pent-up demand is high, much like the economy at large. Did you see what I did there?
Odeta Kushi - You know, I can kind of see why former President Harry Truman once famously said, "Can you give me a one-handed economist please?" In all seriousness, that's a good parallel. The housing market and the macro economy have this in common - demand continues to outpace supply, putting upward pressure on prices. But, for now, I think I'll take my housing market lukewarm, please. Well, that's it for this episode. You know, the Fed clearly faces a very unique challenge in 2022. How to tame inflation without halting the recovery, and the housing market is entering 2022 with double-digit house price growth, strong underlying demand and near record-low supply. A modest increase in mortgage rates due to tighter monetary policy may actually bring some much-needed house price moderation. Thank you for joining us on this episode of the REconomy podcast, be sure to subscribe on your favorite podcast platform. You can also sign up for our blog at Firstam.com/economics. And if you can't wait for the next episode, you can follow us on Twitter. It's @OdetaKushi for me and @MFlemingEcon for Mark, and if you have an economics-related question you'd like us to feature on a future episode, you can always email us at email@example.com. Until next time.
This transcript has been edited for clarity.