Supply still matters: Why US housing inflation relief may be short-lived

[February 28, 2024]  By Howard Schneider

WASHINGTON (Reuters) - U.S. Federal Reserve officials say they are confident housing inflation will finally cool in coming months, a key and long-awaited component of their effort to control overall price increases and secure their turn to interest rate cuts.

The real challenge on that front, however, may be just over the horizon when a pipeline of new apartments starts to run dry while the stock of single-family homes remains short, a recipe for future price pressure in a category accounting for about a third of the Consumer Price Index.

Though their 2% inflation target uses an index that is less sensitive to shelter costs, Fed officials still see housing and rent dynamics as an important, unresolved part of their inflation battle, one that could highlight one of the inherent tensions in today's tight-credit policy stance.

Fed officials acknowledge the difficulty of finding a rate setting that keeps overall demand in check without choking off the supply of new homes and apartments, but some argue that policymakers already have leaned against the economy too hard.

"You think you can snap your fingers and housing can be created...The reality is that is not the case," said Jay Lybik, national director of multifamily analytics for real estate data firm CoStar. After a surge of building boosted apartment supply, CoStar's data signals new unit volumes in sharp decline by early next year, falling to perhaps 50,000 or 60,000 per month versus the estimated 100,000 needed to keep pace with demand.

"We risk a real acceleration in terms of rents that will make things worse come 2025 and 2026," Lybik said.

'LONGER-RUN PROBLEMS'

Housing affordability concerns intensified during the pandemic, with median home prices jumping 50% from its onset through the end of 2022 - though they have since eased - and apartment construction tilted towards higher-end units. Members of Congress have called on the Fed to cut rates both to bring down mortgage costs for consumers and encourage construction; states are toying with rent-control measures and programs to boost supply.

The issues are far bigger than the Fed.

"We have longer-run problems with the availability of housing," Fed Chair Jerome Powell said at a press conference following the central bank's January meeting. "There hasn't been enough housing built," Powell said, but "these are not things that we have any tools to address."

Housing markets vary widely across the country, shaped by local zoning rules, politics and land prices. Still, financing costs heavily influenced by the Fed are key to the investment decisions being made today that will determine future housing supply.

For the Fed's immediate purposes, a coming "disinflation" in overall shelter costs seems almost certain as the record pandemic-era jump in rents and home prices fades into the past, but nonetheless essential to gaining the necessary confidence in declining inflation to begin rate cuts. After rapid rate hikes beginning in March 2022, the policy rate has been held at 5.25%-to-5.50% since July.

'BUILT-IN' INFLATIONARY PRESSURE

While inflation has fallen from 40-year highs, recent progress has been "bumpy" Fed officials acknowledge, with shelter inflation in particular remaining higher for longer than anticipated.

A surprise jump in CPI last month was largely driven by shelter costs still rising by 6% year-over-year versus 4% typically seen before the pandemic when overall inflation was near or below the Fed's target.

A new housing construction is seen as real estate prices rise in Beverly Hills, California, U.S., June 2, 2021. REUTERS/Lucy Nicholson/File Photo

Rent measures assembled in closer to real time aiming to capture current market prices instead of the slow-moving averages in official data indicate price increases have been slowing. For example, an index from online real estate firm Zillow closely watched by Fed officials was rising at a 3.4% annual rate as of January.

"We know it's coming," Arben Skivjani, deputy chief economist for property management and analytics firm RealPage, said of housing inflation's decline in a recent National Association for Business Economics presentation. After rising nearly 16% annually in early 2022, asking rents have shown virtually no increase since last summer, RealPage data shows.

Supply constraints, though, may risk secularly faster inflation.

"We have not built enough homes, we've not built enough shelter for at least a decade...You're short supply of a good that everybody still wants," Mark Fleming, chief economist at First American bank, said at an NABE discussion of housing inflation. "What's going to happen to the price?...Long run, there's definitely built-in inflationary pressure."

MISSING 'PUZZLE PIECE'

Shelter inflation peaked at an 8.32% annual rate in March 2023, the fastest since the early 1980s. The median home price surged nearly 50% from $322,000 in 2020's second quarter as the pandemic began to a peak of $479,000 at the end of 2022, Census data shows, the fastest run-up since the early 1960s.

The median price has since edged back to $417,000, a side effect of Fed rate hikes that at one point pushed the average interest rate on a 30-year home mortgage to nearly 8%, the highest in a quarter century.

But some indexes of more recent home sales show prices rising again, leaving Fed officials hunting for data on home sales and construction to show evidence that demand and supply might move toward better balance.

New Cleveland Fed research on the stark supply-demand imbalance that has powered pandemic-era home price appreciation is one example of the focus on it.

Chicago Fed President Austan Goolsbee called housing a missing "puzzle piece" in the Fed's hope for broadly lower inflation, while Richmond Fed President Thomas Barkin has made analysis of building patterns in his district, comparing communities able to keep pace in new home construction with those that are constrained, a staple of his recent speeches.

EY Chief Economist Gregory Daco said shelter inflation's near-term path was clear. It is headed down, and could over the next couple of months make a substantial contribution to lower headline inflation, a fact he argues is so clear he feels "increasingly frustrated" by the Fed's reluctance to act on it.

Next year, he said, is another story.

"Rent inflation has slowed quite tremendously. That has yet to appear fully" in the data the Fed watches most closely, he said. "Fast forward another six to 12 months...and it may actually move the other direction...That's where the lack of supply comes in."

(Reporting by Howard Schneider; Editing by Dan Burns and Andrea Ricci)

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