The Federal Reserve may finally get the news it has been waiting for since it stopped raising interest rates last year.
A resurgence in consumer prices at the start of 2024 raised concerns that the last mile of the road back to the Fed’s 2% inflation target would be the most difficult.
Market participants concluded that inflation was “stuck” and pushed out their expectations for interest-rate cuts, at times entertaining the possibility of no cuts at all.
A key sticking point has been housing inflation, which is still running about 2.3 percentage points above its prepandemic pace. But April inflation data, along with leading indicators, suggest that progress on this front may be resuming.
That means the long-awaited moderation in housing inflation is probably back on track, which should be hugely reassuring to Fed policymakers. Housing carries a large weight in the key metrics for consumer inflation.
It makes up 34% of the consumer price index and 15% of the personal consumption expenditure price index, the Fed’s preferred gauge of consumer inflation. In both indexes, the weight reflects the rent paid by renters and a rental equivalent for homeowners.
The latter captures what a homeowner would pay if they were to rent their own home. Price changes are calculated from a large sample of apartment rents. Those costs have been on a wild ride over the past five years.
The pandemic radically transformed decisions about where to work and live. People wanted more and different types of living space. Many had the means to pay for it, thanks in part to fiscal support as well as a strong recovery out of the pandemic. The result was a historic surge in apartment rents in 2021 and 2022 that is still having ripple effects in official inflation statistics.
Meanwhile, the past few years have also seen a boom in apartment building. As a result, pressure on rent has abated. Most measures of rents charged on new leases—so-called market rents—stopped increasing at the end of 2022 and are now rising in line with or slower than their prepandemic pace. This slowdown in market rent increases has yet to fully show up in CPI, however.
Housing inflation in the CPI was 5.7% in April, compared with a prepandemic rate of about 3.3%. The disconnect is that the CPI tracks rents paid by all tenants (average rents) not just what landlords charge new tenants.
Over time, rents charged on lease renewals tend to converge to market rents, as landlords and their tenants renegotiate. The main reason official measures of housing inflation have remained elevated is because this convergence was still under way.
The transition to cooler rent dynamics in the CPI has taken longer than many people expected. Historically, measures of market rent lead official measures of housing inflation by about two to four quarters, suggesting that we should have seen more of a slowing by the end of 2023. Instead, increases in CPI housing indexes cooled notably in the first half of 2023 and since then have largely moved sideways.
This has led some market participants and policymakers to doubt their forecast for cooler housing inflation. There is every reason to think that we are close to a turning point.
For a period, renewing leases were still catching up to the pandemic surge in rents, but the majority of indicators show that average rent levels have now fully caught up to that surge. If the catch-up period is over, then the pace of increase in average rents should slow further in coming months.
The longer-than-usual period of convergence has led some to wonder whether the flattening out of market rents will ever fully show up in official measures of housing inflation. Skeptics point out that measures of market rents produced by the private sector are based on different samples than the CPI and may not be representative of the entire urban U.S. population.
Government researchers have started publishing a new-tenant rent index calculated from the same sample as the CPI, which confirms that average rents have caught up to market rents as of the fourth quarter of 2023. The NTR index is subject to revision, but typically the last data points undergo the largest revisions, and subsequent revisions are smaller.
It is notable that the fourth-quarter 2023 convergence still holds after a round of revision. Looking at the widest possible range of available information, it is probably only a matter of time before we see further slowing in housing inflation and overall inflation returns to the Fed’s 2% target.
The April CPI report confirmed further progress: Tenant-occupied rent increased by 0.35% from the month before, marking the slowest pace of increase since August 2021, right before we entered the period of supercharged rent growth.
Our read of the underlying detail is that the slowdown in market rents is resuming in official inflation data after a pause in the second half of 2023. The Fed has said that it “does not expect it will be appropriate to reduce [interest rates] until it has gained greater confidence that inflation is moving sustainably toward 2%.” Many areas outside of housing already show significant progress.
A move lower in housing inflation would probably be the confidence boost the Fed is waiting for.
Source: Barron's
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