Wall Street investors have bought into the Federal Reserve’s assurances that higher inflation won’t last, but a looming trend will test their composure over the coming months: soaring home and rental costs.
With home prices already up about 15 percent from last year and rents soaring at nearly triple their normal rate in just the first six months of 2021, there’s growing concern that housing costs could soon begin to nudge inflation higher. Since shelter makes up about one-third of a key inflation measure, that could undermine the Fed’s message that recent price spikes, which have showed up in everything from airline tickets to ride shares, will slow.
Housing costs could eventually boost inflation by as much as 2 percentage points by the end of next year, though the effects could be felt sooner, according to a forecast from Fannie Mae, the government-run company that stands behind half the country’s mortgages. A gradual buildup beginning later this year could spook markets and feed calls for the Fed to push borrowing costs higher, a move that could choke off economic growth as Democrats fight to hold onto control of Congress.
Officials at the Fed and in President Joe Biden's administration say they expect the supply-chain bottlenecks that have stoked inflation to begin to ease later this year as the economy fully reopens. But housing-driven inflation could also start to rise as higher rents slowly cycle into the official tracking of price increases, a process that may have been delayed because leases are traditionally annual.
“The outlook for rents is key,” said Torsten Slok, chief economist at Apollo Global Management. “With rents going up as the economy reopens, we will continue to see more upward pressure on overall inflation.”
For now, financial markets have shrugged off the recent spurt in inflation, given signs that it is tied to temporary factors that will subside as the country emerges from the pandemic. Instead, investors have grown more worried about long-term growth with the emergence of contagious variants of the coronavirus.
But they're also keeping a wary eye on the housing market. Home prices have spiked over the last year, as social-distancing guidelines and remote work led to an increased awareness of space constraints at home. That unleashed enormous pent-up demand years in the making, as the massive millennial population began to reach peak home-buying age.
At the same time, the Fed’s easy-money response to last year’s economic crisis drove mortgage rates to rock-bottom lows, just as a glut of young adults sought to ditch cramped urban quarters for spacier homes in the suburbs. Those high prices can prevent would-be homebuyers from being able to afford a new house, leading to an even more dramatic increase in rents, which were unusually low for much of the pandemic.
Sales of existing homes were up 45 percent in May over the previous year, according to data compiled by the National Association of Realtors, which recorded a 24 percent increase in home prices over the same period. Frenzied demand led to the typical home lasting just 17 days on the market, with 89 percent of them being sold in less than a month in May.
There were just 1.2 million homes for sale in the U.S. as of the end of May, down 21 percent from last year. And the share of people between the ages of 18 and 34 living with their parents is roughly double that of 20 years ago, so demand is also high for rental units.
Supply, meanwhile, is historically low. The 2008 financial crisis put the brakes on new home construction, leaving the country today with at least 5.5 million fewer houses than needed, according to an analysis prepared for the realtors' association by the Rosen Consulting Group last month.
“This disconnect [between supply and demand] has been under way for a long time,” said Doug Duncan, chief economist at Fannie Mae. “We’re finally seeing it flow into some of the inflation numbers.”
The imbalance is so strong that even slight moderations to supply when the federal bans on evictions and foreclosures expire at the end of the month aren’t expected to make much of a difference.
“Whether it’s a foreclosure or an eviction, I think we’re going to see an uptick in both of those activities,” said Robert Dietz, chief economist at the National Association of Home Builders. “But I don’t think they will play a major role in changing the overall inflation and housing-cost story, which is fundamentally about the number of households and the amount of housing stock available to house that population.”
Even as the country gets beyond the health crisis, housing economists warn that high costs due to that imbalance will persist, thanks to demographic pressures. For one thing, the biggest share of millennials isn’t expected to reach peak home-buying age for another couple of years.
That could boost inflation as measured in two government data series: the Consumer Price Index, an important gauge for financial markets, and Personal Consumption Expenditures, which is more closely monitored by the central bank because it measures a broader range of spending.
Shelter makes up a significant chunk of both CPI and PCE, though inflation data don’t directly include the purchase price of homes, which are considered assets rather than the type of consumer costs that the government aims to track. Rather, they look at rents and what’s known as owners’ equivalent rent, which measures how much someone could charge to rent out their home.
“The assumption is that if the price of the house that you’re buying rises, the rent that would be required to rent that house would also rise,” Duncan said.
But the extent to which owners’ equivalent rent will actually spike is hard to predict, as home prices themselves are much more volatile than so-called imputed rent, so some of the lurking threat might never fully materialize in the inflation data.
“I wouldn’t bet the farm on a big persistent upturn in the [housing component of CPI] based solely on asset prices for homes,” said Joel Prakken, chief U.S. economist at IHS Markit.
He also said the rise in house prices could slow down by the end of the year, as more homes are built and as already-high costs dampen demand.
“Rents are catching up to a very substantial increase in house prices,” said Donald Kohn, a senior fellow at the Brookings Institution and a former vice chair at the Fed. “If house prices continue to rise at a reasonably rapid clip, you could see this rental component of inflation persisting for quite some time, but I don’t think we know that.”
For its part, the Fed will be watching closely to see whether price increases, as a result of rent spikes or dynamics in other sectors, lead to changes in inflation expectations. Spending habits, wages and prices are all tied in part to the psychological phenomenon of whether people expect inflation to pick up.
Some Fed officials have also suggested acting soon to slow the pace at which they’re buying mortgage-backed securities, a process that bolsters the housing market even as prices soar, though they see those purchases as helping keep longer-term rates low beyond just mortgages. That debate is expected to intensify later this year.
Meanwhile, the price of lumber is elevated, and builders have for years reported struggles to hire skilled laborers after the construction pause in the wake of the 2008 crisis drove many workers out of the industry.
Both factors, paired with lingering supply-chain issues from the pandemic, cause delays as builders look to ramp up housing supply, said Joel Kan, associate vice president of economic and industry forecasting for the Mortgage Bankers Association.
“In an environment where there is still housing demand, that’s causing a much more rapid pace of home price inflation than we’ve seen in previous years,” Kan said.
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