The Federal Reserve may have a housing problem. At the very least, it has a housing conundrum.
Overall inflation has eased significantly over the past year. But real estate has proven to be a tenacious – and surprising – exception. According to the Department of Labor, the cost of housing increased 6% in January from a year earlier, and on a monthly basis it increased faster than in December. This acceleration was a major reason for the recovery in overall consumer prices last month.
The persistence of housing inflation poses a problem for Fed officials as they weigh when to reduce interest rates. Housing is by far the largest monthly expense for most families, which means it factors heavily into inflation calculations. Unless property costs fall, inflation as a whole will be difficult to sustainably return to the central bank’s 2% target.
“If you want to know where inflation is going, you need to know where housing inflation is going,” said Mark Franceski, managing director of Zelman & Associates, a real estate research firm. Housing inflation, he added, “is not slowing at the pace we expected or anyone expected.”
Those expectations were based on private sector data from real estate websites such as Zillow and Apartment List and other private companies, showing that rents have only recently risen and are falling sharply in some markets.
For homebuyers, the combination of rising prices and high interest rates has made homes increasingly unaffordable. Many existing homeowners, on the other hand, have been partly insulated from rising prices because they have fixed-rate mortgages with payments that don’t change from month to month.
However, home prices and mortgage rates do not appear directly in inflation data. That’s because buying a home is an investment, not just a consumable purchase like groceries. Instead, inflation data is based on rents. And with private data showing a moderation in rents, economists expect the slowdown to appear in government data as well.
Federal Reserve officials largely ignored housing inflation for much of last year, believing that official data had simply been slow to pick up on the cooling trend evident in private data. They instead focused on measures that exclude housing, an approach they say better reflects underlying trends.
But as divergence persists, some economists inside and outside the Fed have begun to question those assumptions. Economists at Goldman Sachs recently revised up 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 looking at?’ I’d say, ‘I’m looking at real estate because that’s the thing that’s still weird.'”
Data delayed
The persistent nature of housing inflation is not a total mystery. Economists knew it would take time for the rent moderation seen in 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 data is based on a monthly survey of thousands of rental units. However, a given unit is only registered once every six months. So, if an apartment is surveyed in January and the rent goes up in February, that increase won’t show up in the data until the apartment is surveyed again in July. This causes government data to lag conditions, especially during periods of rapid change.
The second reason is conceptual. Most private indexes include rents only when they get new tenants. But the government aims to cover housing costs for all tenants. Because most leases last a year or more, and because those who renew them often get a discount compared to people who rent on the open market, government data will typically adjust more gradually than private indexes.
Public and private data should converge sooner or later. But it is unclear how long this process will take. Rapid rent increases in 2021 and 2022, for example, have led many people to stay put instead of diving into the red-hot rental market. This, among other factors, may have meant it took longer than usual for market rents to filter into government data.
There are signs that a slowdown is underway. Rents have risen at an annual rate of less than 5% over the past three months, compared with a peak of nearly 10% in 2022. Private data sources disagree on how much rent inflation still has to ease, but agree that the trend is expected to continue.
“For the most part, they all say 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 versus apartments
While rent inflation may finally be moderating, the government’s measurement of costs to homeowners has not followed suit; it actually accelerated in the last month’s data. And because more Americans own their homes than rent, owner-occupied homes dominate the housing component of the consumer price index.
The expenses that most people associate with owning a home – mortgage payments, homeowners insurance, maintenance and repairs – are not directly included in measures of inflation.
Instead, the government measures housing inflation for owners by evaluating how much it would cost to rent a similar home, a concept known as owner-equivalent rent. (The idea is that this measures the value of the “service” of providing a home, as distinct from the investment gains of owning it.)
Rental and ownership measures typically move together because they rely on the same underlying data: the survey of thousands of rental units. But in calculating ownership data, the Department of Labor gives more weight to homes comparable to owner-occupied units. This means that if different types of housing behave differently, the two measures can diverge.
That may be what’s happening now, some economists say. A boom in apartment construction in recent years has helped drive down rents in many cities. Single-family homes, however, remain in short supply just as millions of millennials are reaching the stage where they want more space. This is driving up the cost of homes for both buyers and renters. And since most homeowners live in single-family homes, single-family units play a huge role in calculating homeowners’ equivalent rent.
“There is more heat behind single-family households, and there are very good arguments to be made for why that heat will persist,” said Skylar Olsen, chief economist at Zillow.
A stroke of luck 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 inflation for homeowners and renters has only recently diverged. That suggests the January data was a fluke, said Omair Sharif, founder of Inflation Insights, an economic research firm.
“Monthly things in general can be volatile,” Sharif said. The good news in the report, he said, is that rent growth has finally started to slow, making him more confident that the long-awaited slowdown is emerging in the official data.
This conclusion, however, is far from certain. Before the pandemic, different parts of the housing market told generally consistent stories: Apartment rents rose at about the same rate as single-family homes, for example.
But the pandemic has destroyed that balance, driving up rents in some places and lowering them in others, disrupting the relationship between the different measures. That makes it difficult to be sure when official data will cool, or by how much, which could make the Fed more cautious in considering cutting interest rates, said Sarah House, senior economist at Wells Fargo.
“Right now, they’re still taking it for granted that there’s still a lot of disinflation in the pipeline, but that will keep them vigilant in their optimism,” he said, referring to Fed officials. “They have to think about where the shelter will actually land and how long it takes to get there.”