Housing costs imperil rate cuts by the Fed
The Federal Reserve’s irresistible force of steep interest rates has met a seemingly immovable object: the housing market.
The central bank reined in the worst inflation in more than four decades by aggressively boosting borrowing costs. The Consumer Price Index spiked 9.1 percent in June 2022 from a year earlier. By last November, price gains had slowed to 3.1 percent.
But the progress has stalled in recent months. The prime culprit: rising house prices and rents, or what the government calls shelter costs.
Though minor, the inflation uptick has thrown into doubt widely held expectations that the Fed would roll back interest rates sharply this year. It’s unclear how much relief consumer and business borrowers will get. That complicates the outlook for the economy and President Biden’s reelection campaign.
The news: The CPI increased at a 3.5 percent annual pace in March, up from 3.2 percent in the previous month, the Bureau of Labor Statistics said on Wednesday. So-called core CPI, which excludes more volatile food and energy prices, was unchanged at an 3.8 percent.
Driving the pickup were shelter costs, which climbed 5.7 percent over the past year. That accounted for more than 60 percent of the increase in the core index. Rents for primary residences rose 5.7 percent while owners’ equivalent rent, a proxy for how much homeowners would pay to lease their home, jumped 5.9 percent.
What’s happening: The Fed’s antiinflation fight hasn’t played out in textbook fashion. The goal was to curb
consumer demand so that companies would moderate price increases. But it turned out much of the inflation problem was being caused by COVID-related supply constraints. Once the logistics were smoothed out, prices on goods fell.
Meanwhile, consumer spending remained healthy, thanks to a strong job market. Prices for services — everything from car insurance to medical care — continued to expand.
And shelter costs were actually pushed higher by rate increases. Home sales dried up as potential sellers were handcuffed by their existing low mortgage rates. Bidding on the relatively few homes on the market sent prices up. And a dearth of reasonably priced housing, compounded by a rate-induced slowdown in construction, has kept rents from falling quickly.
Shelter is the biggest component of the CPI, accounting for 36 percent of the index in March. Excluding owners’ equivalent rent, or OER, the core index rose just 1.9 percent year-over-year in March, according Mark Zandi, chief economist at Moody’s Analytics.
“OER growth will continue to moderate, but only slowly due to measurement issues due in part to the affordable housing shortage,” he said.
Why it matters: Wall Street started the year with a consensus view that policymakers would drop the benchmark federal funds rate up to six times for a total of 1.5 percentage points, starting as early as March. (The rate now ranges from 5.25 percent to 5.5 percent.)
A decline of that size would almost certainly keep the economy humming. Consumer mortgages and auto loans would get cheaper, as would business loans for expansion. Tech and biotech startups would find it easier to raise money.
But after three straight months of disappointing inflation data, investors now fret that the Fed won’t act until September and will reduce rates just twice. Last month, Fed officials indicated in their own projections that they would cut rates three times this year, for a total of three-quarters of a percentage point.
However, Fed chair Jerome Powell has said they won’t cut rates until inflation is firmly on track to return to their 2 percent target.
“The Fed is committed to 2 percent inflation, regardless of what’s going ‘on under the hood,’” said Claudia Sahm, a consultant and former Fed economist. “They will not start to reduce interest rates until inflation starts moving down again, and that’s going to be a while.”
It’s important to note that the Fed focuses more closely on another measure, the Personal Consumption Expenditures Index, which isn’t so heavily weighted toward housing. PCE for March won’t be released for two weeks. But core PCE rose
2.8 percent on an annual basis in February.
The political angle: The economy is robust and unemployment has been below 4 percent for more than two years. But Americans give Biden low marks for his handling of the economy.
Prices remain high, even if increases are not as large as they were in the past. Moreover, groceries and gasoline are two regular purchases that play an outsize role in consumers’ views of the economy. Energy prices expanded 2.1 percent in March, the first annualized increase since February 2023. The food index rose 2.2 percent.
“Today’s report shows inflation has fallen more than 60 percent from its peak, but we have more to do to lower costs for hardworking families,” Biden said in a statement. “Prices are still too high for housing and groceries, even as prices for key household items like milk and eggs are lower than a year ago. I have a plan to lower costs for housing — by building and renovating more than 2 million homes — and I’m calling on corporations including grocery retailers to use record profits to reduce prices.”
Final thought: The Fed is in a bind.
Shelter costs are a big reason it doesn’t yet feel comfortable cutting rates. But the best way to make housing more affordable is to cut rates.
“The Federal Reserve is caught between a rock and a hard place,” said Brian Bethune, an economist at Boston College, who criticized the Fed for taking rates too high. “The last two hikes went past the stop sign,” he said, referring to quarterpoint increases in May and July of last year.
The question now: Will the Fed reverse course and use lower rates to get the housing market moving again?