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The Fed’s Housing Problem

23 April 2024

Hotter-than-expected inflation data is fueling concerns over the timing and frequency of potential interest rate cuts by the Fed this year. 

The Fed is highly data dependent and persistent inflation has increased the chances of a no-landing scenario where inflation remains high or even accelerates despite efforts to tame it. Austan Goolsbee, the head of the Chicago Fed, puts most of the blame on housing: “The biggest danger to the inflation picture in my view… (is) the continued high inflation in housing services.” A policy dilemma arises from the fact that rents and property values are being pushed up by a long-standing shortage of new housing units.

In March, both headline and core Consumer Price Index (CPI) inflation rates, excluding shelter costs, were lower compared to when shelter costs were included. Specifically, the year-on-year (y/y) inflation rates were 2.3% (versus 3.5% including shelter) for headline CPI and 2.4% (versus 3.8%) for core CPI.

It’s worth noting that CPI inflation tends to be higher than the Personal Consumption Expenditures (PCE) inflation rate, which is the Federal Reserve’s preferred inflation measure. Over the past 12 months ending in February, the difference between the two has been 0.7% for headline inflation (3.2% for CPI versus 2.5% for PCE) and 1.0% for core inflation (3.8% for CPI versus 2.8% for PCE).

This discrepancy occurs for various reasons, with a significant factor being shelter inflation. Shelter costs, particularly rent, have a substantial weight in the CPI (36%) compared to the PCE (15%). Rent in the CPI increased by 5.7% y/y through March, although this was a decrease from the previous year’s peak of 8.3%.

Federal officials acknowledge that the rent inflation components of the CPI and PCE lag behind rents in current leases because they reflect the rent of both existing and new leases. They anticipate rent inflation to continue moderating, reflecting the moderation in indexes of current rents. Notably, CPI tenant rent inflation fell to 4.5% (seasonally adjusted annual rate) over the three months through March, significantly below the 5.7% y/y increase.

Apart from rent, other factors contribute to housing inflation. One challenging aspect is insurance costs. The increased risk of natural disasters such as fires, hurricanes, floods, and tornadoes has led to significant hikes in insurance premiums. Home insurance rates tend to increase more rapidly in the Personal Consumption Expenditures (PCE) measure compared to the Consumer Price Index (CPI). For instance, in February, home insurance rose by 7.8% in the PCE, while in March, it increased by 4.6% in the CPI.

The challenge arises from a negative feedback loop triggered by higher interest rates impacting building activity. As interest rates rise, new construction slows down, contributing to increased rents. In regions like the Northeast and Midwest, where municipalities have struggled to build new housing, inflation is lingering longer compared to the West or South, where construction activity is more robust and inflation is declining rapidly. This cycle of higher rates suppressing new construction ultimately results in elevated rents and home prices. Waiting for rents to fall only prolongs the delay in housing activity necessary to increase the supply of housing units in the market.

A recent study by the Federal Reserve of San Francisco analyzed inflation by categorizing it into interest-rate responsive and unresponsive categories, examining whether each category historically decreased following a surprise interest rate hike. The research findings indicate that the current inflationary pressure primarily stems from the unresponsive categories. Additionally, the study reveals that the interest-rate sensitive categories tend to react to monetary policy changes with significant delays, suggesting the possibility of further disinflation in the future. It emphasizes the importance of reducing housing inflation as a crucial step toward achieving more disinflation.

The Fed needs to move away from being data dependent. We’re at a turning point where looking in the rearview mirror to steer policy is the wrong approach. Instead, the Fed should adopt a strategic, forward-looking approach to guide its policy decisions.

Housing Affordability Watch

CMI monitors the latest developments and offers insights on solutions to Canada’s housing affordability crisis

The March 27th edition of CMI’s Housing Affordability Watch highlighted initiatives that CMHC could explore to improve efficiency in the housing finance system and help restore affordability to Canada’s housing market. In a series of posts, we’re delving into each of these options in detail.

In the first instalment of our series, we looked at the US mortgage-backed securities (MBS) market to identify best practices that could be applied to Canada’s National Housing Act Mortgage-Backed Securities (NHA MBS) program. In our second instalment, we explored the potential benefits of establishing an insured mortgage repo (repurchase) facility and the infrastructure that would be required to support it.

In our third instalment, we examine the importance of achieving transparent pricing in the NHA MBS market. CMHC has never established a framework to ensure an active secondary market for mortgage-backed securities (MBS). Transparent pricing would encourage money market funds and other liquidity pools to trade in NHA MBS, laying the groundwork for a liquid MBS market. Read the full article here: Improving Efficiency in the NHA MBS Market – Transparent Pricing is Paramount


Independent Opinion

The views and opinions expressed in this publication are solely and independently those of the author and do not necessarily reflect the views and opinions of any person or organization in any way affiliated with the author including, without limitation, any current or past employers of the author. While reasonable effort was taken to ensure the information and analysis in this publication is accurate, it has been prepared solely for general informational purposes. Any opinions, projections, or forward-looking statements expressed herein are solely those of the author. There are no warranties or representations being provided with respect to the accuracy and completeness of the content in this publication. Nothing in this publication should be construed as providing professional advice including investment advice on the matters discussed. The author does not assume any liability arising from any form of reliance on this publication. Readers are cautioned to always seek independent professional advice from a qualified professional before making any investment decisions.

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