The Federal Reserve may have a housing problem. At the very least, it has a housing conundrum.
Headline inflation has fallen significantly over the past year. But housing has proved a persistent — and surprising — exception. Shelter costs rose 6 percent in January from a year earlier and rose faster on a monthly basis than in December, according to the Labor Department. That acceleration was a big reason for the rebound in overall consumer prices last month.
The persistence of housing inflation poses a problem for Fed officials as they consider when to cut interest rates. Housing is by far the largest monthly expense for most families, meaning it weighs heavily on inflation calculations. Unless housing costs fall, it will be difficult for inflation as a whole to return sustainably to the central bank’s 2% target.
“If you want to know where inflation is going, you have to know where housing inflation is going,” said Mark Franceski, managing director at Zelman & Associates, a housing research firm. Housing inflation, he added, “is not slowing at the rate that we expected or expected.”
Those expectations were based on private-sector data from real estate websites like Zillow and Apartment List and other private companies that showed rents have only been rising recently and falling altogether in some markets.
For homebuyers, the combination of rising prices and high interest rates has made housing increasingly unaffordable. Many existing homeowners, on the other hand, have been partially insulated from rising prices because they have fixed-rate mortgages with payments that don’t change from month to month.
However, house prices and mortgage rates are not directly reflected in the inflation data. That’s because buying a home is an investment, not just a consumer purchase like groceries. In contrast, the inflation figures are based on rents. And with private data showing rents are moderating, economists are looking for the slowdown to show up in government data as well.
Federal Reserve officials largely dismissed housing inflation for much of the past year, believing that official data was just slow to confirm the cooling trend evident in private data. Instead, they focused on measures that exclude housing, an approach they felt better reflected underlying trends.
But as the divergence continues, some economists inside and outside the Fed have begun to question those assumptions. Economists at Goldman Sachs recently raised their forecast for housing inflation this year, citing rising rents for single-family homes.
“There’s clearly something going on that we don’t understand yet,” Austan Goolsbee, president of the Federal Reserve Bank of Chicago, said in a recent interview. “They ask me, ‘What are you watching?’ I’d say, “I’m watching housing because that’s the thing that’s still weird.”
Data Latency
The stubborn nature of housing inflation is not an absolute mystery. Economists knew it would take time for the rent restraint seen in the private sector data to make its way into the Labor Department’s official Consumer Price Index.
There are two reasons for this delay. The first is technical: the government’s figures are based on a monthly survey of thousands of rental units. However, a given unit is only surveyed once every six months. So if an apartment is researched in January and the rent increases in February, that increase will not show up in the data until the apartment is researched again in July. This makes government data lag behind conditions, especially during times of rapid change.
The second reason is conceptual. Most private listings only include rentals when they get new tenants. But the government aims to cover housing costs for all tenants. Because most leases last a year or longer, and because those who renew their leases often receive a discount relative to people renting on the open market, government data typically adjusts more gradually than private indices.
Public and private data should eventually converge. But it is not clear how long this process will take. The rapid rise in rents in 2021 and 2022, for example, has led many people to stay put rather than enter the hot rental market. This, among other factors, may have done more than usual to filter market rents into the government data.
There are signs that a slowdown is underway. Rents rose at an annual rate of less than 5 percent in the past three months, from a peak near 10 percent in 2022. Private data sources disagree on how much further rent inflation needs to fall, but agree that the trend should continue.
“For the most part, everyone is saying the same thing, which is that rent inflation has moderated significantly,” said Laura Rosner-Warburton, senior economist at MacroPolicy Perspectives, an economic research firm.
Houses vs. Apartments
While rent inflation may finally be moderating, the government’s measure of costs for homeowners has not followed suit. It actually accelerated in the last month’s data. And because more Americans own their homes than rent, homeownership dominates the shelter component of the CPI.
The expenses most people associate with home ownership—mortgage payments, homeowner’s insurance, maintenance and repairs—are not directly included in measures of inflation.
Instead, the government measures housing inflation for landlords by estimating how much it would cost to rent a similar home, a concept known as landlord equivalent rent. (The idea is that this measures the value of the “service” of providing a home, as opposed to the investment gains from owning it.)
Renting and ownership measures typically move together because they are based on the same underlying data—the survey of thousands of rental units. But to calculate ownership figures, the Labor Department gives more weight to residences that are comparable to owner-occupied units. This means that if different housing types behave differently, the two measures may diverge.
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. However, single-family homes remain in short supply as millions of millennials reach the stage where they want more space. This increases the cost of homes for both buyers and renters. And because most homeowners live in single-family homes, single-family homes play a large role in calculating owner-equivalent rent.
“There is more heat behind single-family, and there are very good arguments for why that heat will continue,” said Skylar Olsen, chief economist at Zillow.
A Fluke, or something more?
Other economists doubt that the rise in inflation in January is the start of a more lasting trend. Single-family home rents have been outpacing apartment rents for some time, but only recently has inflation for owners and renters diverged. That suggests January’s data was a fluke, argued Omair Sharif, founder of Inflation Insights, an economic research firm.
“Month-to-month things in general can be volatile,” Mr Sharif said. The good news in the report, he said, is that rent growth has finally started to moderate, making him more confident that the long-awaited slowdown is showing up in the official data.
However, this conclusion is far from certain. Before the pandemic, different parts of the housing market generally told consistent stories: Rents for apartments rose at about the same rate as those for single-family homes, for example.
But the pandemic has upset that balance, driving rents up in some places and falling in others, disrupting the relationships between the different measures. That makes it hard to be sure when the official data will cut or by how much — which could make the Fed more cautious as it considers a rate cut, said Sarah House, senior economist at Wells Fargo.
“Right now, they’re still assuming there’s still a lot of deflation in the works, but it’s going to keep them cautious in their optimism,” she said, referring to Fed officials. “They have to think about where the shelter actually is and how long it takes to get there.”
