The REconomy Podcast™: Breaking Down the Federal Reserve’s Efforts to Control Inflation

In this episode of the REconomy Podcast™ from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi discuss the components driving the Consumer Price Index and the Federal Reserve’s efforts to bring inflation under control. 

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Listen to the REconomy Podcast Episode 43:


“Even as annual house price appreciation is slowing, shelter inflation will continue to increase for some time. And as the Fed acts to tame inflation today, lagging shelter inflation, as measured in the CPI, will be a challenge to overcome for a couple of years.” – Mark Fleming, chief economist at First American


Odeta Kushi - Hello and welcome to episode 43 of the REconomy podcast, where we discuss economic issues that impact real estate, housing and affordability. I am Odeta Kushi, deputy chief economist at First American and here with me is Mark Fleming, chief economist at First American. Hey Mark. Today's episode will be all about one number - 9.1.

Mark Fleming - Hi Odeta. That's a very specific and surprisingly lacking more digits for your tastes. You usually are at 9.1 and many more. But I do know exactly what you're referring to. That's the recent history and record-breaking June Consumer Price Index inflation rate.

Odeta Kushi - That was a mouthful, but you're right, Mark. And, while we've covered inflation in previous episodes, I think given how central it is to everything from Fed policy to the housing market, it's worth a follow-up episode. Inflation as measured by the Consumer Price Index or CPI grew at an unsettling 9.1% annually in June, 0.3 percentage points higher than the consensus consensus estimates of 8.8% and 0.5 percentage points higher than in May.

Mark Fleming - And the largest contributors were in the essentials - gasoline, shelter and food. I can't really think of anything more essential than that trio.

Odeta Kushi - That's right, energy inflation was up 7.5 percent in just the last month, and 42% over the last year, the largest annualized increase since 1980. Shelter inflation was up 5.6% year over year, which is the fastest increase in shelter inflation since 1991. And food inflation was up 10.4% compared to a year ago. I mean, it's no wonder consumer confidence continues to fall, the cost of living is going way up.

Mark Fleming - We are definitely earning our chops as dismal scientists right now. These are definitely difficult times, especially when it's the cost of essentials that are rising fastest., but there is a silver lining here. The Federal Reserve realizes how important it is to get inflation under control. And there's some early evidence that inflation is actually subsiding that didn't show up in those numbers that we were just referring to.

Odeta Kushi - Yes, more recent data on food and energy, particularly gasoline prices show that prices are down in recent weeks, oil prices are back below $100.

Mark Fleming - Woohoo below 100. Again, another potentially positive development is there as a consumption shift away from goods. Remember when the pandemic hit, we shifted from services to goods. And that's the area where we've had all the supply-constrained inflation challenges. Now that shift is back, away from goods to services. Again, there was a surge in spending on goods during the pandemic and it stressed out - that's the technical econ jargon - supply chains and contributed to higher prices. So shifting that spending back to services may actually help to alleviate those price pressures.

Odeta Kushi - And, in fact, that consumer shift away from goods caught retailers off guard. Now, they have excess inventories and are cutting prices to move old inventory. You may have noticed price cuts for things like clothes, sports equipment, or even home decor. I actually held off on purchasing a couple of things that I want for the house knowing that more deals were likely on the way.

Mark Fleming - Ooh, let's focus on this for a second - slight digression from the topic. You deferred purchases because of an expectation that they will be less expensive, meaning experiencing deflation, in the near future. Listeners, that's exactly why deflation is so feared. What if everyone acted like Odeta? Ever the economist.

Odeta Kushi - Just call me Spock. But, to your point Mark, if I, as a consumer know it will be less expensive tomorrow than today, then I will choose not to buy today. So that causes people to defer consumption and could even prompt a recession. So deflation is not great. The flip side - if inflation is too high, people will bring forward future consumption. Hence why the Fed has a 2% inflation target. Not too hot, not too cold, just right.

Mark Fleming - Indeed. And in the immortal words of Richard Thaler, the Nobel Prize winning economist. Luckily, we aren't all like Spock, many of us are more like Homer Simpson.

Odeta Kushi - And that might be a good thing. And then another potential reason that prices may moderate is because consumers are spending down elevated savings, which may result in less discretionary spending. And, finally, consumer inflation expectations have improved somewhat. According to Wall Street Journal reporting of the Federal Reserve Bank of New York survey, the bank said in its June survey of consumer expectations that respondents see the annual inflation rate three years from now at 3.6%. That's actually down from their expectation in May of 3.9%. The bank also said respondents expect the annual inflation rate five years from now to be 2.8% down from their May expectation of 2.9%. So, these are just some reasons that inflation may begin to subside. But there is one other factor we haven't discussed that will do just the opposite.

Mark Fleming - Yes, one of the essentials in the trio shelter. I don't know, seemingly kind of important, the roof over my head to protect me from the rain, the heat and the cold. Everybody kind of needs it. We all know by now that annual house price growth skyrocketed over the course of the pandemic and remains in the double-digits still, even though in recent months, we do see some softening. Rents have also increased significantly at the same time. In both cases, supply-demand imbalances are at the heart of why we see such high amounts of growth in both rents and house prices. Yet the CPI that we just discussed doesn't actually take house prices directly into account at all, when calculating inflation because it considers the purchase of a home as an investment, rather than a consumption item. The consumption is the shelter, not the buying of the home. Shelter, which is the service that housing provides, is relevant to the CPI as a consumption item. That's what we measure or attempt to measure. For renters, it's easy. They're paying rent for the service of shelter. So the cost of shelter is rent. But, for homeowners, the cost of shelter is this implicit rent that owner occupants would have to pay if they were renting their homes. That's a podcast episode for another time to explain how they do that. But we impute what the rent would be for all those homeowners.

Odeta Kushi - So housing costs and the CPI report are represented by two primary components, the monthly cost for people who rent their homes, and something called the owners equivalent rent, which is what homeowners would have to pay each month to rent their own house.

Mark Fleming - That's right. And this is really important because shelter inflation accounts for about 40% of the core CPI. That's the core, excluding food and energy, the other two of the trio, by the way. And, as we briefly mentioned, shelter inflation was up 5.6%, year over year in June, the fastest increase since 1991. But, here it is. It's not likely to come down anytime soon.

Odeta Kushi - Well, that's ominous, and odd because we know from higher frequency data that monetary tightening is curtailing demand for for-sale housing. And we know from our house price indices that house price growth is beginning to moderate.

Mark Fleming - We know that it is happening now. But this has to do with the method of measurement in the CPI. And that happens to be much more backward looking. So, it's reflecting what happened in the past, not what's happening now. By virtue of how its measured, shelter inflation lags rental and house price increases by six to 12 months. According to a recent working paper, entitled the coming rise in residential inflation. Dismal science all over again here. Estimating that shelter inflation will keep overall inflation elevated throughout 2022 and 2023, contributing as much as 2.6 percentage points to core CPI. It's tough to get back to your target of two, when one major component alone is already above that.

Odeta Kushi - So that means that the rapid growth in rent expense and house prices over the last year is only beginning to hit the headline CPI figure now, not to mention that house price growth and rent growth remain elevated in today's market.

Mark Fleming - That's right. So, even as annual house price appreciation is slowing, shelter inflation will continue to increase for some time. And as the Fed acts to tame inflation today, lagging shelter inflation, as measured in the CPI will be a challenge to overcome for a couple of years.

Odeta Kushi - Well, I certainly don't envy the Fed's job right now. But priority number one for the Fed is to cool inflation. But, of course, by cooling the economy, they risk recession. But the Fed is actually hoping to construct what is called a soft landing, working to ensure that its efforts to tame inflation do not tip the economy into a recession.

Mark Fleming - That's right and this would require keeping the labor market steady Eddie. The theoretical framework for a soft landing in the labor market draws on the idea of this thing called the Beveridge curve. No, not to drink. There's a D in the spelling of Beveridge there, which is an economic graphical representation of the relationship between unemployment and the job vacancy rate in the labor market. This relationship is what we refer to as downward sloping. That is a higher rate of unemployment typically coincides with a lower rate of vacancies. Think about it. Why would there be lots of unfilled jobs at the same time as lots of unemployed workers, unless there is a fundamental skills mismatch between the job seekers and the job offers? But, according to this relationship, the Fed's policy tightening should reduce vacancies and push up unemployment.

Odeta Kushi - For the two decades prior to the pandemic this relationship has held in a consistent range. And I'll make sure to add the chart to my Twitter feed to kind of show this graphical representation. In any given period, unemployment is broadly determined by two factors, new separations from employment, that's layoffs and quits. And existing job seekers - people still seeking work. The lower the separations rate, the fewer new job seekers are available to fill vacancies and the more difficult it becomes for prospective employers to find prospective employees - a matching problem. This leads the Beveridge curve to become steeper the lower the unemployment rate.

Mark Fleming - But, in today's hot labor market, there are plenty of job openings, but the separations rate has fallen since the early pandemic, as employers have sought to retain their existing employees. And that's caused the Beveridge curve to, as we say, "shift out." More job openings relative to any level of unemployment.

Odeta Kushi - So the Fed's hope is that tighter monetary policy will reduce job openings without increasing separations, shifting the Beveridge curve in or, in other words, the labor market will reduce its excess demand for labor - lower vacancies - rather than reduce existing employment - rising unemployment. It is possible for the Fed to architect a soft landing, but only if we can get back to the pre-pandemic norm.

Mark Fleming - And remember, the reason for the Fed tightening to begin with is to try and tame that inflation and get back to its 2% target, just safely enough above the dreaded zero and risk of deflation. And that's done by reducing overall demand, which, theoretically at least, means all those job openings won't be as necessary anymore.

Odeta Kushi - Theoretically, at least. Well, that's it for today. Thank you for joining us on this episode of the REconomy podcast. If you have an economics-related question you'd like us to feature on a future episode, you can email us at We love to hear from our listeners. 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. Until next time.

This transcript has been edited for clarity.

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