The latest inflation measure from the US government, an 8.4% annual increase in the Consumer Price Index (CPI), has left market watchers with little doubt that the US Federal Reserve bank will hike interest rates by 0.75 percentage points at its next meeting in November.
That news had markets skipping, fearing the recession that high rates could bring, and welcoming the potential easing of interest rates that a recession might bring. And even that dubious logic faces a difficult reality.
Among the most-watched subcategories of the overall inflation number is the cost of housing, and particularly the measure of home prices used to construct CPI, called Owners Equivalent Rent of Residences (OER). It tries to figure out, on average, how much a homeowner would pay if they had to rent a home like their own on the open market.
The nature of this indicator is that it is laggy, because the average includes people who bought years ago and people who bought last month. During the height of the pandemic, as housing prices surged, it didn’t increase as much as indicators that attempt to measure rents in real-time. That’s arguably one reason the Fed was late in starting to raise rates and fight inflation, and one reason economists predicted higher inflation on the horizon last year.
In 2022, OER caught up, pushing inflation higher, even as more real-time data suggests the rental market is peaking and starting to come back to earth.
The Fed has a supply-side problem
As the Fed raises interest rates, the cost of mortgages is going up, reaching levels not seen in the US in decades. That is pulling demand out of the market and leading home prices to cool. The National Association of Realtors (NAR) expects existing home prices in the US to fall 1.2% in 2023. Still, that would bring price levels back to... about where they are right now, since NAR expects existing home prices to increase 9.6% overall by the end of 2022.
There’s also a supply side issue: Who’s going to sell their home? After the financial crisis of 2008, regulators changed underwriting rules to get rid of predatory mortgages with changing interest rates. That means that more Americans have 30-year fixed-rate mortgages, and spiking rates won’t force them to sell. A decade of low interest rates mean many homeowners bought or refinanced into cheap mortgages. Even if they’d like to sell their house and move, doing so would be prohibitively expensive unless they can afford an all-cash purchase of a new home, or a substantial downpayment. That will keep the supply of houses low—and prices high.
“What we anticipate continuing to see going forward, is that the inventory, the listings of existing homes available for sale [remains low]—we have that data going back for single unit homes to the early 1980s. It was never lower than it was in earlier this year,” Morgan Stanley housing analyst Jim Egan told Bloomberg.
This is terrible news for first-time homebuyers and for renters. But it’s also trouble for Fed chair Jay Powell, whose strategy is based on the idea that higher interest rates will lower inflation. If rate hikes are likely going to freeze housing markets for the foreseeable future, a major component of the inflation measure—the OER—is unlikely to fall. That increases the odds that the Fed will overcorrect and push the economy past an increasingly unlikely “soft landing” and into a deeper recession.
The choices facing policymakers are difficult. More can be done to increase housing supply, particularly in metropolitan areas, but easing regulations to approve new projects isn’t a quick fix. The Fed’s monetary policy committee will have to hope that other prices fall faster to make up for home prices stuck at high levels, and give it an excuse to pause its interest rate hikes.