By Nick Timiraos
Stalled inflation this year hasn’t derailed the Federal Reserve’s plans to eventually cut interest rates. That’s because it expects a slowdown in housing costs to eventually drag inflation close to its 2% target.
The problem: It has been waiting for that slowdown for 1½ years now, and it still hasn’t arrived. The slowdown might simply be delayed. But some analysts worry it’s not going to happen because of changing dynamics in the housing market. If so, that would significantly weaken the case for lower rates.
Housing has played a large role in the inflation of recent years because its cost rose so much and carries such large weight. It is one-third of the consumer-price index and around one-sixth of the price index of personal-consumption expenditures, the Fed’s preferred inflation measure.
It is also, in theory, predictable. Government statisticians don’t use home prices to calculate inflation because a home is partly an investment. Instead, they use monthly rents to capture what tenants pay to rent a house or apartment, and what a homeowner would in theory pay to rent her own home.
Market rents—rents on newly signed leases—surged three years ago, reflecting the unusual demand for more space unleashed by the pandemic, strong income growth and historically low inventories of homes for rent or purchase. Single-family home rents rose 14% in 2022, according to CoreLogic.
But year-over-year rent growth slowed to 3.4% in February, reflecting increased competition from new apartment supply and tepid inflation-adjusted income growth. Apartment rents have notched similar declines, according to Zillow.
Because only a minority of leases turn over each year, changes in market rents are reflected in inflation with a lag. Accounting for that lag, Fed officials, Wall Street investors, and private-sector economists have expected housing inflation to slow since late 2022 based on what has already happened with market rents.
Housing inflation has indeed slowed from a peak of 8.2% one year ago—but only to 5.6% in March, “a much slower pace than pretty much anybody anticipated,” said Jay Parsons, head of residential strategy at Madera Residential, a Texas-based apartment owner. The Labor Department is scheduled to report April inflation on Wednesday.
Deconstructing inflation
Housing helps explain why core inflation, which excludes volatile food and energy prices, has stalled in recent months, contrary to expectations of a continued cooling. Core PCE inflation was 2.8% in March, down from 5.6% in 2022 but not much lower than in December.
Housing “has not behaved the way we thought it would,” Chicago Fed President Austan Goolsbee said in an interview last month. “I still think it will, but if it doesn’t, we’re going to have a hard time” bringing inflation back to 2%.
To understand why, break core inflation into three different baskets: goods, housing and nonhousing services. To get all the way to 2% inflation, the Fed doesn’t need 2% for all those categories.
In the decade before the pandemic, core inflation was slightly below 2%, the result of inflation in goods running at about minus 1%, housing at 2.5% to 3.5%, and nonhousing services at slightly above 2%.
Much of last year’s slowdown in inflation was because goods prices returned to their prepandemic trend. For inflation to get back to 2%, nonhousing services inflation has to drop to less than 3% from 3.5% now, and housing to around 3.5% from 5.8%.
If inflation stays higher, Fed officials are likely to hold interest rates at their current levels, the highest in two decades, until they see more concrete evidence that the economy is slowing.
The ‘last lag’ or the last mile?
Many economists still think it’s only a matter of time before housing inflation reflects the slowdown in new leases that began two years ago. It might be taking longer than expected because more renters are renewing their leases instead of buying a home, deterred by high mortgage rates. That could lengthen the time it takes for lower rents from newly signed leases to show up in overall inflation.
“I still think that check is in the mail, but unfortunately, it’s taking longer for that check to arrive than I anticipated,” said David Wilcox, an economist at Bloomberg Economics and the Peterson Institute for International Economics. “I just don’t see an alternative outcome other than those low lease rates eventually manifest themselves in the official price indexes.”
Stalled inflation has fanned fears the Fed might have to weaken the labor market, risking recession, to finish the “last mile” of bringing down inflation. But that might not be necessary if prices, such as for housing, reflect economic conditions from a few years ago rather than now.
Higher car-insurance costs or hospital-service prices, for example, reflect big increases in auto prices and hospital wages two years ago, respectively, said Omair Sharif, founder of research firm Inflation Insights. “It’s the ‘last lag’ story, not the ‘last mile’ story,” he said.
Demand tailwinds
Some doubt whether housing will help as much as anticipated in bringing inflation down. Rents tend to be sensitive to wages and income, and as long as those expand solidly, rents might not slow as much.
A key reason market rents have moderated is that the industry is adding a record amount of new apartment supply. Some industry executives say, though, that that supply is being quickly absorbed because of increased immigration and solid job and wage growth.
“One of the surprises of the last six months, specific to multifamily, has been the reacceleration of demand,” Parsons said.
At Camden Property Trust, a Houston-based owner of 58,000 apartment homes, the share of tenants moving out to buy homes has fallen to 9%, the lowest in the company’s three-decade history and down from a traditional move-out rate of 15% to 18%.
To be sure, rent growth at Camden, which fell to 3% last year from a record 13% in 2022, is expected to be less than 1% this year.
“Most folks believed you would have had a massive falloff in rental growth throughout the Sunbelt,” said Ric Campo, chief executive of Camden. “But what’s happening is there’s been just a whole lot more demand than most people expected.”