US housing inflation: the sleeping giant that might tip the Fed’s hand

July 21, 2021

Todd David, the executive director of the Housing Action Coalition, a charity that works on housing policy in San Francisco, says all signs are pointing to a resurgence in rental costs in the Bay area after the pandemic-driven slump.

“A year from now, if we are not adding significant supply, which there’s no indication that we will . . . prices in San Francisco for rents are [going to be] at all-time high again,” he said. “The trend is up.”

Housing expenses are the sleeping giant that could tip the scales of the increasingly heated debate on US inflation. They are quickly emerging as a pivotal indicator for officials at the Federal Reserve, within the Biden administration, and among private economists.

So far this year, the shelter component of the consumer price index has shown smaller increases compared to the soaring expense of items such as used cars, airfares and energy.

But housing costs have nonetheless been edging up, showing a year-on-year increase of 2.6 per cent in June compared to a 1.5 per cent annual rise in February.

If shelter prices remains relatively contained, they are likely to help ensure that inflation can be controlled, validating expectations at the Fed and the White House that price pressures will subside.

But if they keep increasing at even a small but steady pace on the back of booming house values in many cities, it could signal that high inflation will be sustained for longer than expected.

Shelter costs account for about a third of the overall CPI, and comprise rental prices as well as what is known as “owner-equivalent rent”, the estimated cost of a house occupied by an owner if it were rented out.

“We calculate the market won’t be fully in balance until 2023 or 2024. So I’m not sure that the uptick in rents is particularly shortlived,” said Ali Wolf, chief economist at Zonda, a property market advisory group.

She added: “Assuming the economy continues to improve, and we continue to see the job growth numbers get better, I do think there will continue to be some upward pressure on rents.”

So far, the rise in rental costs in the economy has not been particularly large and has not even bounced back to pre-pandemic rates that were comfortably above 3 per cent.

But if it continues, or even accelerates, it might pose a significant problem for the Fed because the cost increases would be embedded in rental contracts, making them hard to reverse. Higher rents could also affect inflation expectations, which are a crucial factor in monetary policymaking.

The Fed’s preferred measure of inflation, the personal consumption expenditure index, does not weight housing costs as much as the CPI, but the central bank may find any rising expenses in shelter increasingly hard to ignore.

“People don’t buy a used car every month whereas many pay rent every month,” Tim Duy, a professor at the University of Oregon and chief economist at SGH Macro Advisors wrote in a note this week.

During a pair of congressional hearings last week, Jay Powell, the Fed chair, was repeatedly quizzed by lawmakers on the affordability of housing, in a sign that rising costs were becoming increasingly sensitive politically, for Democrats and Republicans alike.

“I don’t know what housing prices will do in the future. But there is just a lot of demand,” Powell said. “Even if mortgage rates go up as they ultimately will, I think we will be looking at a lot of demand. Then the question will be how much supply can be brought to the market? And that’s really out of our control.”

Housing experts say that supply constraints remain significant as homebuilders try to catch up with demand after pausing during the early stage of the pandemic. Changing zoning restrictions to allow for more housing to be built is an often contentious process that can take a long time to achieve.

At the moment, Wolf says the biggest rent increases are mainly occurring across the Sunbelt states like Arizona and Texas, with big coastal cities including San Francisco seeing much more tepid jumps.

One worry among some economists is that when pandemic-era moratoriums on evictions are lifted later this year, landlords might increase rents to make up for lost income, based on higher property values and the expectation that tenants are flush with income.

But other economists do not believe that housing inflation will become problematic, pointing to the fact that the shifts are slow and cyclical. “We’re just not all that concerned or convinced that we’ve seen a regime change in inflation yet,” said Julia Coronado, co-founder of MacroPolicy Perspectives.

Even so, Janet Yellen, the Treasury secretary, last week expressed some concern about excessive heat in the housing market, particularly to the extent that it is affecting low and middle-income families.

“I do worry about affordability and the pressures that higher housing prices will create for families that are first-time homebuyers or have less income,” she told CNBC.

At the Fed, the debate around housing inflation is occurring as the central bank is preparing to start slowing the rate of its monetary support for the economy, which has resulted in low interest and mortgage rates that have helped fuel the boom in house prices.

Some Fed officials are arguing for the central bank to more rapidly curtail its $40bn in monthly purchases of mortgage-backed securities in order to take some heat out of the housing market, but others argue the effect would be modest.

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