You’re Going to Hear More About “Harmonizing” Inflation. Why It Matters (June 5, 2024)

There is a push to drop the biggest, and most inconvenient, component of major inflation indexes. It may mean quicker rate cuts now–and more payback later.

By Lisa Beilfuss
June 5, 2024

There is a nascent push underway to “harmonize” inflation in the U.S. Investors should consider that a euphemism for eliminating the biggest component of major inflation indexes, which would allow officials to declare victory over inflation for now.

Investors already familiar with “harmonized inflation” might think of it as what the Europeans do to create a measure of inflation that is comparable across countries. Different preferences mean, for example, that olive oil is weighted more heavily for some countries than butter. Those advocating harmonizing U.S. inflation data are narrowly focused on one feature of the Euro area’s Harmonized Indices of Consumer Prices, or HICP. Where U.S. inflation indexes include owner-occupied housing in the form of owner-occupied rent, or OER, the European version altogether excludes the category.

OER is based on what homeowners say it would cost to rent their own homes, and it is how government economists turn housing, an asset, into a service. The component is weighted heavily in major U.S. inflation baskets, comprising 34% of the core consumer price index and 13% of the core personal consumption expenditure index. OER rose at a 5.8% annual pace in April, down from 8% a year earlier but still about double the pre-pandemic rate and triple the Federal Reserve’s overall 2% target. 

Stubbornly high OER is a key roadblock to rate cuts, at least when one is simply looking at the inflation side of the central bank’s mandate. Not surprisingly, OER is drawing increased attention and criticism. As economists at Goldman Sachs put it, the largest component of the CPI tracks a price that nobody actually pays–an imputed rental payment from homeowners to themselves. The idea is that OER is derived from observed rental prices in nearby similar homes, which can be tricky when about two-thirds of Americans own their homes.  

It makes sense, then, that an effort would be afoot to nix the OER from the CPI and PCE for the purpose of monetary policy decisions. That effort may gain momentum as other central banks begin easing and downward inflation forces in the U.S stall or reverse. Consider a four-month string of import price increases suggesting goods disinflation may already be exhausted, and Deutsche Bank’s estimate that the immigration surge knocked a half-point from core PCE from the immigration surge. 

Economists at Moody’s Analytics are emphasizing harmonized inflation. Matt Colyar, economist there, published a recent report noting that while the CPI was up 3.2% in the first quarter relative to a year earlier, its harmonized version was up 2.3%. Core CPI (which excludes food and energy) rose 3.8% in the first quarter, compared with a 2% increase in the harmonized version.  

What is more, Moody’s recently developed a harmonized version of the total and core PCE, the latter of which is the Fed’s preferred inflation metric. The firm’s harmonized core PCE has been running below 2.5% since September and was up just 1.7% in March. 

Colyar says the purpose of creating the new harmonized PCE isn’t to promote the idea that the Fed should shift to targeting a new measurement, and he says it isn’t an exercise in excluding inconvenient components from inflation estimates. Even so, he says that if the U.S. government measured inflation the way the European Union does, the Fed would likely have already started loosening monetary policy. 

Cherry-picking data or excluding components to justify policy isn’t new or unusual. But potentially harmonizing U.S. inflation metrics in order to exclude OER and superficially achieve 2% inflation is particularly problematic. 

First, OER may be broadly misunderstood. It is a misnomer that the Europeans exclude owner-occupied housing from inflation metrics because it is flawed. Omair Sharif of Inflation Insights says the Euro area’s HICP excludes the component in part because of practical issues such as differing regulations and high shares of public housing in some European countries.  

What is more, Sharif notes that the EU has said it is working to include owner-occupied housing in its inflation index. That point itself exposes calls to harmonize U.S. inflation metrics as somewhere between disingenuous and illinformed. 

Second, it is conceptually flawed to strip out owner-occupied housing inflation from major inflation gauges. As economist Ethan Harris says, the flow of services from owner-occupied housing (where OER is one way to measure it) is an important contributor to overall consumption. Home prices, according to the Core-Logic-Case-Shiller home price index, rose 45% from January 2020 to June 2022. They dipped 5% for the next seven months and since then have been rising at about a 7% annualized pace. Those gains don’t exist in a vacuum. One example: The average cost of home insurance rose 11.3% in 2023, according to S&P Global.  

Third, if U.S. policymakers were to advance harmonized versions of major inflation indexes, they would widen the gap between official inflation metrics and the reality of households and businesses. The mismatch already exists because consumers can’t back out the costs of food and energy, each of which are already excluded from core inflation gauges.   

It is possible that growth data deteriorate faster than a push to harmonize inflation data materializes. Consider the latest data from the Job Openings and Labor Turnover Survey from the Labor Department, which showed that the number of job openings per unemployed fell back to pre-Covid levels. That is a development the Fed will be happy to see, says Juliette Declercq of JDI Research, given the emphasis central bankers have put on JOLTS data and that particular ratio. “But be careful what you wish for, because there is no stabilization in sight,” she says.

Either way, investors should pay attention to efforts by some economists and policymakers to “harmonize” U.S. inflation data for the purpose of excluding the big and currently inconvenient owner-occupied rent component. Such discussions will help reveal policy preferences and potentially pave the way to quicker rate cuts now–and more dramatic payback later.