Measuring inflation is a complex task, especially when calibrating monetary policy responses to rising prices. Residential rent, in particular, makes up for over a third of the Consumer Price Index, of which owner’s equivalent rent, closely tied to mortgage rates, accounts for a quarter. While the Fed is raising rates to bring overall inflation down, the paradox is that higher rates might actually exacerbate inflationary pressures related to rents.
In its attempt to quell the post-pandemic surge in inflation, the Federal Reserve embarked on one of its most aggressive rate-hiking campaigns. Some point fingers at the Fed or at the U.S. Administration as the culprit for the rising prices, but it’s improbable that U.S. government policy played a significant role. This isn’t just a U.S. problem; countries like Singapore, the United Kingdom, and Brazil have all faced similar inflationary surges. This strongly indicates that the root cause lies not in domestic policies but in the sharp resurgence of consumer demand at a time when the supply of goods and services was severely constrained, which had global effects.
Whatever its origin, however, solving inflation is now the Fed’s responsibility, and it only has two tools at its disposal: raising interest rates or controlling the money supply.
Of these tools, controlling the money supply is probably the most effective, but also the most difficult to employ. Straining liquidity can easily trigger cash shortages that lead to financial crises, such as preventing debt rollovers or igniting damaging bank runs. This explains why the Fed’s balance sheet, a measure of injected money into the economy, actually expanded earlier this year amidst the inflation fight, when a few banks faltered. By injecting liquidity into the system, the Fed managed to stave off the crisis from spreading.
This leaves us with interest rates as the safer instrument. The notion is that higher interest rates render debt more costly, discouraging both investment, which relies on financing, and consumption, for example by making credit card, mortgages and auto loans more expensive. Reduced demand for goods and services should naturally drive prices down, as basic economics theory declares.
But steering the U.S. economy is far more complex than what Economics 101 suggests. Unintended consequences can ripple from any government action. Consider the housing rental market. While the headline Consumer Price Index (CPI) has nearly normalized, rent inflation remains elevated and largely unresponsive to the Fed’s higher rates (see graph). The Fed’s answer to this is that “more work is needed,” which means that high rates will remain in place for some time, potentially even rising.
But will higher rates bring down rent inflation? This seems unlikely and, in fact, they might make inflation worse. According to Trading Economics, total housing inventory is hovering at multi-decade lows, in fact as much as 50% below normal levels, and the resulting scarcity of available rental properties keeps rental prices elevated. In sectors such as homebuilding, which heavily relies on leverage, the situation is unlikely to change soon, thus keeping housing inventory low and rents high.
Even more noteworthy is the stark contrast between mortgage rates paid by current homeowners and rates charged for new mortgages, a difference that is now at a 50-year high (see graph). This contributes to the housing shortage, as current homeowners seeking to sell would be faced with nearly twice the interest costs, making new mortgages prohibitive and trapping them in place. This is also reflected in the “owner’s equivalent rent” component of inflation, which gauges the cost a homeowner would incur to rent a similar property, factoring in mortgage availability and cost.
Another indication of the impact of higher rates on inflation is the divergence between price changes for new and used cars compared to leased cars. While the new car segment of the CPI increased by only 2.9% year-on-year and used cars fell by 5.6%, leasing costs (heavily influenced by the interest rate on leases) surged by 10.8%.
The consumer, despite these challenges, still looks strong. Although the excess savings accumulated during the pandemic stimulus injections are nearly depleted, much of these savings went towards debt repayment, resulting in household debt to GDP ratios at historic lows (see graph). Also, while credit card delinquencies have risen significantly from last year (an item that generated a considerable amount of press coverage), they remain well below historical levels. This aligns with the fact that consumers’ debt burdens have lightened considerably.
All this is good news, but shelter inflation remains problematic because of its outsized impact on household budgets, especially for young people and for the lower income segments. If this persists, it could feed further into wage inflation as workers demand more pay just to be able to keep up with rising rents.
The Federal Reserve faces a daunting task ahead. On one hand, the economy appears robust by nearly all metrics, even surpassing expectations. This makes it difficult for the Fed to consider ending its string of rate hikes when inflation still lingers above its target.
On the other hand, rent inflation remains high and credit delinquencies are on the rise, and both can be attributed to some extent to higher interest rates. Higher shelter costs along with declining savings indicates that consumer spending will weaken, cooling off economic activity in the months ahead. Raising rates further or keeping them at elevated levels for an extended period, as Fed officials seem to be considering, could exacerbate the slowdown and tip the scales towards an unwelcome recession.
The Fed has been very successful thus far at curbing inflation while preventing the economy to stall. But continuing down the path of “higher for longer” risks cooling things too much while, paradoxically, preventing inflation to fall further due to the impact of elevated rates on shelter and on the cost of consumer credit.
To avoid this trap, the Fed should start contemplating how to ease its foot off the brakes. A timely action in that regard could earn the current Fed leadership the Holy Grail of a soft landing. Otherwise, they will simply confirm the common belief, justified or not, that the Fed always messes things up.
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