THE U.S. ECONOMY IS IN THE MIDST OF A major transition, and the housing sector is key to the outcome. Reductions in home sales and housing production, as well as a slowdown in house price appreciation, are essential to a continuation of the current economic expansion. However, the evolving housing slowdown is putting perverse upward pressure on government measures of core consumer price inflation. This conundrum has the central bank in a box, and the Federal Reserve will find it tough to achieve a “soft landing” for housing and the economy while keeping inflation in the Fed's professed target range.

ECONOMIC TRANSITION Housing was the major growth engine during most of the economic expansion that began at the end of 2001, fueling economic activity through record levels of sales and production as well as through massive capital gains and wealth effects.

It's fair to say that the exuberant housing sector soared to unsustainable heights in 2005, driven by an influx of investors/speculators seeking to share in the housing boom. The housing explosion, in turn, overheated the economic expansion and sowed the seeds for a slowdown in both housing and the economy.

The house price explosions eventually created serious affordability problems in the single-family and condo markets, the Fed weighed in with a series of interest rate hikes designed largely to rein in the housing boom, and many investors/speculators saw the writing on the wall and retreated from the housing market. As a result, the housing boom topped out in the second half of 2005, and the slowdown is now contributing to a systematic slowing of economic growth into a healthy range that should be sustainable for years to come.

INFLATION IRONY The evolving slowdown in housing and the economy, including a marked slowdown in house price inflation, looks like the perfect outcome for a central bank committed to promoting sustainable economic growth with low inflation. Unfortunately, government statisticians have gotten in the way, causing the housing slowdown to put upward rather than downward pressure on the inflation measures the Fed is trying to hold down.

The Fed is explicitly targeting government measures of core consumer price inflation. These measures exclude house prices but include large housing components that are driven by “owners' equivalent rent.” In essence, the statisticians measure changes in market rents and pretend that housing costs for all homeowners rise or fall with the rent measures.

Rents are now rising because eroding affordability has shunted housing demand away from home buying, putting downward pressure on homeownership rates as well as on rental vacancy rates. Indeed, this process is likely to put upward pressure on market rents and core consumer price inflation for some time to come, in the face of weakening markets for single-family homes and condo units.

THE FED MUST ADJUST The Federal Reserve has been fussing about upward pressure on core inflation for quite a while, stepping up short-term interest rates at every policy meeting between mid-2004 and mid-2006, but it has not acknowledged the perverse upward pressure on core inflation now coming from the housing downswing.

The bizarre influence of “owners' equivalent rent” actually makes tighter monetary policy inflationary, a perverse result if there ever was one; moving forward, the Fed should qualify its concerns about core inflation. Otherwise, monetary policy will be tightened too much, with serious downside consequences for both the housing sector and the economy.

Chief Economist, NAHB Washington, D.C.

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