The Federal Reserve may have a housing problem. At least there is a housing conundrum.
Over the past year, overall inflation has eased significantly. But housing has proven to be a persistent and surprising exception. Protection costs rose 6% in January compared to the same period last year and grew faster month-over-month than in December, according to the Labor Department. This acceleration was a major cause of the overall consumer price increase last month.
The persistence of housing inflation poses a problem for Federal Reserve officials as they consider when to cut interest rates. Housing costs are the largest monthly expense for most families, so they weigh heavily when calculating inflation. Unless house prices fall, it will be difficult for overall inflation to sustainably return to the central bank's target of 2%.
“If you want to know where inflation is going, you need to know where housing inflation is going,” said Mark Franceski, managing director of housing research firm Zelman & Associates. He added that housing inflation “is not slowing down at the rate we expected or anyone expected.”
These expectations are based on private sector data from real estate websites like Zillow and Apartment List and other private companies, which shows rents have barely risen recently and are falling outright in some markets.
For home buyers, rising prices and high interest rates are making it increasingly difficult to purchase a home. On the other hand, many existing homeowners have been partially protected from price increases because they have fixed-rate mortgages where monthly payments do not change.
However, home prices and mortgage rates do not appear directly in inflation data. That's because buying a home is an investment, not a consumer purchase like groceries. Instead, inflation data is based on rents. And with private data showing rents softening, economists are looking to see if the slowdown is also showing up in government data.
Federal Reserve officials largely dismissed housing inflation for most of last year, believing official data had been slow to catch up with the cooling trend seen in private data. Instead, they focused on measures that exclude shelters, an approach that better reflects underlying trends.
But as these differences persist, some economists inside and outside the Federal Reserve are beginning to question these assumptions. Goldman Sachs economists recently raised their outlook for housing inflation this year, citing rising rents for single-family homes.
“There are clearly things going on that we don’t yet understand,” Austan Goolsbee, president of the Federal Reserve Bank of Chicago, said in a recent interview. “They ask me, ‘What are you looking at?’ I’d say, ‘I’m looking at houses because it’s still weird.’”
delayed data
The stubborn nature of housing inflation is not a complete mystery. Economists knew that it would take time for rent adjustments seen in private-sector data to be reflected in the Labor Department's official consumer price index.
There are two reasons for the delay. The first is the technical part. The government's data is based on monthly surveys of thousands of rental properties. However, certain units are inspected only once every six months. So, if you survey an apartment in January and the rent increases in February, that increase won't show up in your data until you survey the apartment again in July. This causes government data to lag behind, especially during periods of rapid change.
The second reason is conceptual. Most private indices include leases only when new tenants are acquired. However, the government aims to cover housing costs for all renters. Government data are generally adjusted more gradually than private indices because most leases last a year or more and people who renew their leases often receive a discount compared to those who rent on the open market.
Public and private data must eventually converge. But it's unclear how long that process will take. For example, the sharp rise in rents in 2021 and 2022 has led many people to stay put rather than jump into the hot rental market. This may have meant, among other things, that it took longer than usual for market rents to filter into government data.
There are signs that a slowdown is underway. Rents have increased at a rate of less than 5% per annum over the past three months, down from a peak of nearly 10% in 2022. Private data sources disagree on how much rent inflation should ease, but they agree on the trend. It must continue.
“Most everyone is saying the same thing: Rent inflation has eased significantly,” said Laura Rosner-Warburton, chief economist at economic research firm MacroPolicy Perspectives.
house vs apartment
Rental inflation may finally be easing, but government measures of costs for homeowners have not followed suit. In fact, last month's data showed an acceleration. And because more Americans own their homes than rent, owner-occupied homes dominate the shelter component of the Consumer Price Index.
The costs that most people associate with homeownership (mortgage payments, homeowners insurance, maintenance and repairs) are not directly included in inflation measures.
Instead, the government measures owner-occupied housing inflation by assessing how much it would cost to rent a similar home. This is a concept known as owner-equivalent rent. (The idea is to measure the value of the “service” provided by providing a home separate from the investment benefits of homeownership.)
Rent and ownership measures typically move together because they are based on the same underlying data: a survey of thousands of rental units. However, to calculate ownership figures, the Department of Labor gives greater weight to homes that are comparable to owner-occupied homes. This means that the two measurements may differ if different types of houses behave differently.
That may be what is happening now, some economists say. A boom in apartment construction in recent years has helped drive down rents in many cities. But as millions of millennials reach the stage where they want more space, single-family homes remain in short supply. This is driving up home prices for both buyers and renters. And because most homeowners live in single-family homes, single-family homes play a large role in calculating the owner's equivalent rent.
“There’s more heat behind single-family homes, and there’s a very good argument as to why that heat will persist,” said Skylar Olsen, Zillow’s chief economist.
Is it a coincidence or something more?
Other economists suspect January's rise in inflation is the start of a more sustained trend. Single-family home rents have been outpacing apartment rents for some time, but it wasn't until recently that owner-occupier and renter inflation began to differ. Omair Sharif, founder of economic research firm Inflation Insights, argued that this meant the January data was a fluke.
“Typically, monthly work can be uneven,” Mr. Sharif said. The good news in the report is that rent growth is finally starting to cool, providing confidence that the long-awaited slowdown is showing up in official data.
However, that conclusion is not certain. Before the pandemic, different parts of the housing market were telling a generally consistent story. For example, apartment rents have risen at about the same rate as single-family home rents.
But the pandemic has disrupted the balance, sending rents higher in some places and lower in others, disrupting the relationship between the various measures. “This could make the Fed more cautious as it considers rate cuts, as it is difficult to be sure when or how much the official data will cool,” said Sarah House, chief economist at Wells Fargo.
“Right now they're assuming there's still a lot of disinflation in the pipeline, but that's going to keep them optimistic,” she said, referring to Fed officials. “They need to think about where the shelter is actually going to be and how long it will take to get there.”