Housing Market Decoded: Why is inflation so sticky?

Real Estate News

By Lisa Sturtevant

It’s all about housing, which has an outsized effect on the Consumer Price Index — and is contributing to the Fed’s lack of action on interest rates.

Inflation has been a tough nut to crack. The overall inflation rate of 3.3% remained unchanged in May, according to Consumer Price Index (CPI) data released by the U.S. Bureau of Labor Statistics (BLS) on June 12.

That same day, following a meeting of the Federal Open Market Committee, Chairman Jerome Powell announced that the board was leaving interest rates unchanged. The Fed’s economic projections were also updated, indicating only one rate cut — rather than three or four — was expected in 2024.

The CPI release is one of two critical economic reports that the Federal Reserve watches as they deliberate monetary policy. (The other is the employment situation report.) Powell has stated repeatedly that they will not cut rates until they see clear evidence that inflation is moving toward the 2% target.

But here’s the problem: In this unusual economic and housing market environment, the housing (or shelter) component of the CPI is keeping inflation propped up, which means interest rates are remaining high. Higher rates, in turn, lead to less housing supply and higher home prices.

It is a vicious cycle that can be untangled by addressing how housing costs enter into the CPI calculation.

Housing has an outsized impact on inflation

Inflation is based on changes in the CPI, which is a measure of the prices of various goods and services consumers purchase. Home prices are not included in the CPI, as the purchase of a home is considered an investment rather than an expenditure by the BLS. But rents and a concept referred to as “owner equivalent rents” are included. The owner equivalent measure is an attempt to track how much homeowners could charge if they rented their home out.

Shelter accounts for 30-40% of the CPI. So, how shelter costs are trending will have an outsized effect on the overall inflation measure — more important than food or energy, which can be more volatile on a month-to-month basis.

Timing is everything

The BLS collects data on rents every month, but the majority of that data is from renters who are in the middle of a lease — which means the rent data included in the CPI does not reflect the advertised rents or rents for new tenants, which is a more accurate measure of the housing market.

Because those rent changes are not collected until a lease ends, the rent data in the CPI can reflect prices that are 12 to 18 months old.

For example, a recent national report found that average apartment rents had declined year over year back in August 2023. According to the CPI data, the rent index was still rising by nearly 8% that month.

What does it all mean for interest rates?

The Federal Reserve has been stalwart in its commitment to achieving a 2% inflation rate. While the Fed technically watches a related measure of inflation, the Personal Consumption Expenditure, public attention is closely paid to the CPI measure.

The Fed is well aware of how rent data is collected and how shelter costs lag in the CPI, keeping inflation higher than it truly is in the economy.

It is mostly a communication issue, but the Fed could move on cutting rates before the official inflation measure hits 2%, which could help spur housing supply and help prospective homebuyers.

Dr. Lisa Sturtevant has been involved in research on economic, demographic and housing market issues for more than 20 years. She is currently Chief Economist at Bright MLS, where she leads research and forecast activities for Bright and serves as a thought leader on the housing market. The views expressed in this column are solely those of the author.