The optimal way for a central bank to regard housing inflation? Ignore it
The rising cost of housing has been a powerful force keeping U.S. inflation above the Fed’s target. Per the personal consumption expenditures (PCE) price index, housing costs are 5 percent higher than they were one year ago. Core PCE inflation excluding housing, on the other hand, has essentially returned to the Fed’s 2 percent annual target. Even as inflation in core goods and services began to decline in early 2022, housing inflation continued to pick up steam for another 12 months. Meanwhile, the Federal Reserve began a series of 11 interest rate hikes, aiming to tame a core PCE inflation rate heavily driven by housing.
Loading figure 1…
In a new working paper, three Minneapolis Fed economists arrive at a stark finding for monetary policymakers facing this situation: Ignore housing prices (Minneapolis Fed Working Paper 808: “How Should Monetary Policy Respond to Housing Inflation?” by Javier Bianchi, Alisdair McKay, and Neil Mehrotra). The economists update a standard New Keynesian economic model to reflect the reality that housing supply—unlike most goods and services—adjusts very slowly in response to changes in demand. Under these conditions, they find that the optimal policy is very close to one that disregards housing entirely, focusing primarily on returning nonhousing goods to the inflation target.
Some prior research suggests the opposite—in the sense that monetary policymakers should place more weight on sectors with stickier prices and where supply is most costly to ramp up. And rents are especially sticky given standard 12-month leases. However, Bianchi, McKay, and Mehrotra find that notwithstanding sticky prices in the housing sector, the insight flips when incorporating the fact that housing is largely “supply determined” (in contrast to most “demand determined” goods) and must therefore be rationed when demand increases.
In the economists’ static and dynamic models, when demand for housing increases—say, from the effects of a pandemic—new houses and apartments do not come online immediately to meet demand. Instead, households compete harder over existing stock, creating inefficient “congestion externalities” as each frantic home-hunter lowers the odds of finding a house for everyone else. In the static setting, the monetary policymaker faces a trade-off: Tolerate the overheated housing market or impose a lower level of consumption (a recession) in the rest of the economy to temper the congestion in housing.
In the dynamic model, nominal rent prices can rise over time as rents are gradually renegotiated. In the meantime, however, households search excessively among a too-small supply of houses—which remain underpriced relative to demand—causing the familiar congestion. The economists calibrate their model using recent U.S. data on housing mobility, housing expenditures, the cost incurred when searching for housing, and contribution of new leases to the overall rent level.
To tame housing and thus overall inflation, the monetary authority in the model must tighten policy to a high degree, causing consumption of nonhousing goods to fall by 10 percent.
In the model, a monetary authority is confronted with an increase in the demand for housing (expressed as an increase in its household expenditure share from 15 percent—similar to the current PCE level—to 18 percent). The central bank has three possible policy paths: (1) Target a level of zero overall inflation, (2) ignore housing and target zero inflation only in nonhousing goods, or (3) follow an optimal policy that maximizes the welfare of households.
When the central bank targets the general price level (including housing), returning inflation to zero comes at the cost of a significant recession in the nonhousing sector of the economy. Housing supply fails to respond to the increase in demand, and consumers’ consumption of housing and search effort are relatively unresponsive as the central bank hikes interest rates. To tame housing and thus overall inflation, the monetary authority in the model must tighten policy to a high degree, causing consumption of nonhousing goods to fall by 10 percent.
The optimal policy that maximizes welfare for households is “almost indistinguishable,” the economists write, from a policy that ignores housing and solely stabilizes the prices of nonhousing goods: “Although search congestion costs create a trade-off for monetary policy, the optimal policy essentially disregards these costs.” While the housing market is overheated and consumers are searching at an excessive level, “this cost is small relative to the recession in the goods market that is needed to counter it.”
An adjusted version of the model replicates the catch-up shelter inflation recently observed in the U.S., in which the relative price of housing (which is fixed in the short term) falls at first from a demand shock but returns to trend as existing leases turn over. The policy implication does not change: Maximizing household welfare means essentially ignoring housing inflation.
This insight does not mean that policymakers in general should be unconcerned about the rising price of housing. Rather, it appears that as long as housing supply remains severely constrained, using monetary policy to try to slow the rising price of shelter inflicts too steep a cost on the rest of the economy. “Our findings suggest a reappraisal of the measure of inflation targeted by central banks,” the economists write. It appears to matter a great deal which sectors are driving inflation, and “it is crucial to consider whether the level of activity in a sector is demand-determined or”—like housing—“the market adjusts through demand rationing.”
Read the Minneapolis Fed working paper: “How Should Monetary Policy Respond to Housing Inflation?”
