Bloomberg News
Federal Reserve officials anticipate moderating housing costs driving disinflation in the months ahead, but a national shortage of homes could spoil those expectations.
Last month, during his annual address in Jackson Hole, Wyo., Fed Chair Jerome Powell said the elevated housing costs captured by recent inflation readings do not reflect the central bank’s true progress on curbing price growth in that sector.
“The market rent slowdown has only recently begun to show through to that measure,” Powell said. “The slowing growth in rents for new leases over roughly the past year can be thought of as ‘in the pipeline’ and will affect measured housing services inflation over the coming year.”
Economists agree that rent growth rates have slowed down since peaking during the pandemic years and that such a trend often takes time to show up in inflation reports, given how housing costs are measured. But some say the trajectory of where shelter costs are heading is muddied by shortages in most major markets across the country.
The Fed’s primary monetary policy tool — the federal funds rate — is used to influence consumer spending, to help steer demand for goods and services into alignment with their supply. For housing, which has been underbuilt since 2008 and artificially restricted with building codes and other localized rules for decades, supply is still well short of demand, KPMG chief economist Diane Swonk said.
“Getting supply to meet demand in a market where supply has been so dramatically constrained — not just temporarily, but structurally for decades — is difficult,” Swonk said. “We’re a long way from the market being anywhere near in balance, and that’s something the Fed has to watch because price is the ultimate equalizer, and prices don’t come down when supply and demand are so far out of balance.”
The Fed’s latest Beige Book, which compiles economic data from across the Federal Reserve System’s regional reserve banks, stated that “nearly all districts” reported dealing with constrained for-sale housing supply. Many also noted headwinds on financing new housing construction, both for sale and for rent.
While Fed officials have made no commitments about future rate hikes, recent readings on inflation data and employment figures have trended in a favorable direction and indicated that the Federal Open Market Committee, or FOMC, could soon stop raising rates.
The short supply of homes not only raises questions about the movement of prices in the months ahead, but also could also create issues for the Fed when the central bank decides to stop raising interest rates and, eventually, cut them. Swonk said other monetary authorities around the world have already had to quickly reverse course on policy changes after sharp rebounds in home buying activity.
“It’s forced other central banks to rethink and go back in and raise rates again,” she said. “It’s something the Fed is just concerned could be something that we have, especially given our extraordinary situation in the United States, where supply is so far below demand that it’s even been below the suppressed level of demand that we have because of higher rates.”
Powell acknowledged this risk in his Jackson Hole speech, noting that “after decelerating sharply over the past 18 months, the housing sector is showing signs of picking back up,” which “could warrant further tightening of monetary policy.”
Rising housing costs have consistently been among the leading drivers in overall inflation dating back to last year, even as many other price categories have stabilized. The White House Council of Economic Advisors estimates that shelter costs contributed to roughly half of overall headline inflation through the first quarter of this year, roughly double the share from June 2022.
The two main national price indices, the Consumer Price Index, or CPI, and Personal Consumption Expenditure, or PCE, index — the Fed’s preferred indicator — both measure housing costs by rents and rent equivalents for homeowners. In this sense, the Fed’s most direct impact on housing affordability — mortgage rates — do not directly factor into the data the Federal Open Market Committee considers when setting monetary policy.
David Wilcox, senior fellow at the Peterson Institute for International Economics and director of US economic research at Bloomberg Economics, said rents and home purchase prices tend to move in the same direction over time, but “economically, the mechanics of that relationship are pretty loose” and it could take years before that relationship “asserts itself,” meaning rents could continue to stabilize or even fall as sale prices rise.
“If you’re talking about what’s on the horizon for the next six months, the next year, the next 18 months, you would be well served to focus on what’s going on on the rental market and set aside the purchase market,” Wilcox said, referring to the housing portion of inflation indexes.
Still, mortgage rates are a key component of the housing sector, which is relevant to the labor market and overall economy. Because of this, Fed officials often point to mortgages as an example of the effectiveness of their monetary policy changes. In Jackson Hole, Powell noted that mortgage rates more than doubled over the course of 2022, moving up in lockstep with each rate hike.
The average rate on a new mortgage is now more than 7%, and the week ending Sept. 1 saw the lowest indexed level of mortgage application activity since December 1996, according to the Mortgage Bankers Association — a 30% drop from the same time period last year.
But some say this decline in activity has less to do with diminished demand than prospective homebuyers reacting to the extremely low levels of supply.
“There’s still a pretty good amount of competition whenever a unit comes on the market, despite rates being at over 7%,” said MBA vice president and deputy chief economist Joel Kan. “Rates are high, but because of how low inventory is and the fact that we still do have pretty healthy levels of housing demand … if there’s a need to buy, and the buyer has the means, they’re trying to go ahead with it.”
Swonk said the national housing shortage is the result of a “perfect storm” of market and policy trends dating back to the subprime mortgage crisis of 2007 and 2008. Since that episode — which was triggered by risky lending activity and overbuilding in many markets — home builders and lenders have shied away from speculative developments, she said, leading to sustained underbuilding. Meanwhile, restrictive zoning laws dating back to the 1970s have made it difficult to build multifamily and even entry-level single-family homes in many areas.
This limited supply was met with a surge in demand from 2020 into 2022 as the Fed slashed interest rates to their lower bound, resulting in a flurry of purchases and refinances. A report from the real estate listing website Redfin estimates that more than 90% of homeowners locked in a mortgage rate below 6% by the middle of last year, with more than 80% paying less than 5% and more than 60% below 4%.
Wilcox said this has contributed to a “lock-in” effect, which disincentivizes homeowners from putting their properties on market.
“Current, incumbent owners are reluctant to sell,” he said. “They’re locked into their current residences, and that means that there’s no supply on the market for purchasers to come in, and that puts a prop underneath purchase prices.”
For now, asking rents have largely stabilized. Over time that trend will work its way into inflation measures as more survey respondents report signing or renewing leases at prices reflecting those changes.
Some economists say rental rates could even come down in some markets, which are currently experiencing an uptick in apartment construction, particularly among properties with 20 or more units, according to the U.S. Census Bureau.
“Supply constraints seem to be easing,” Christian Weller, an economist and senior fellow at the Center for American Progress said. “Between construction starts and completion there is a time lag, so this will take some time, but given what we see in the rental market, with new rents close to flat relative to where they were in previous months, the hope is that we are in the process of easing prices.”
