Housing stands in the way of a September Fed pivot

Federal Reserve Chair Jerome Powell sounds as committed as ever to crushing the worst inflation in 40 years. But the economy is shifting under him, and markets are increasingly attuned to the possibility that a sharp change in Fed policy – or at least tone – could come as soon as September.

It makes sense to prepare for such an outcome. Slowing economic growth may conspire with cheaper commodities and bloated inventories to help cool inflation in the coming months. By then, the Fed should also have its policy rate at a level it considers to be restrictive, putting further downward pressure on prices.

That would allow the central bank to slow its pace of interest rate increases or even signal a pause at future meetings. Although the economy is cooling fast, Powell might even be able to salvage the job market with such a move. Yet the stars must align for a Fed “pivot” to materialize so soon:

– The U.S. must post three months of declining core inflation, measured month-over-month.

– The pace of home price appreciation must cool (in market price gauges, not the inflation index).

– Energy prices should remain contained.

As Powell said last month, he wants to see a “series” of reports with inflation coming down before he entertains a change in strategy. A widely followed nowcast from the Cleveland Fed suggests that the consumer price index, excluding volatile food and energy prices, posted a month-over-month decline in June and may do so again in July. A third decline in August would give the Fed a strong excuse to change its story. Of course, the Fed will have only two reports in hand for its preferred measure, core PCE, but it can assume it will follow a similar trajectory to CPI.

The big wrinkle is housing, one of the most idiosyncratic elements in the inflation basket. Housing flows into inflation through rents and a category called owners’ equivalent rent, a metric based on surveyed estimates of what people think their homes would rent for. As such, reported housing inflation lags market prices by many months. Because of the mechanics alone, housing is likely to keep exerting upward pressure on the index into 2023, and there may come a point in the not so distant future when policy makers may decide to look past the housing element in the index.

But that can’t happen until market prices actually start to cool to a meaningful degree. There’s no doubt that transactions are slowing rapidly, and this is likely to bleed into prices soon enough. But in part because of the near-historic shortage of inventory, prices have remained resilient so far, giving the Fed little cover yet to look through housing.

Finally, energy prices must remain under control for the Fed to relax its stance in September. Policy makers typically don’t calibrate policy based on volatile food and energy prices, but the sharp moves of the past six months have influenced the way consumers perceive inflation. Powell believes that inflation expectations can be a self-fulfilling prophecy and thinks keeping them anchored is critical. It’s hard to imagine the Fed backing down if oil prices blow past $120 a barrel again. (West Texas Intermediate crude futures plunged below $100 on Tuesday, a big boost to the pivot thesis if it can be sustained.)

So why is the Fed even waiting? Certainly, some investors would love for the central bank to pivot now as a reaction to signs of weakening real consumer demand and a softening manufacturing sector. That’s highly unlikely to happen, however. Waves of inflation tend to come in batches, and if the Fed stops tightening short of 2.5% – its idea of the neutral fed funds rate that’s neither stimulative nor restrictive – it could be remembered as a historic policy failure should prices surge anew or fail to come back to the Fed’s 2% target.

But the situation will be different in a few months. The slump in the S&P 500 Index will have lasted 10 months in October, matching the average length for US bear markets. With all the bizarre crosscurrents in today’s economy, even the most avowed stock market bears must acknowledge that by then, there’s a real – albeit highly uncertain – possibility that everything could change on a dime.

– – This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.