Thursday, March 11, 2021

Rent: From Headwind To Tailwind

Rent is one of the major components of both the Consumer Price Index (CPI) and the personal consumption expenditures deflator (PCED). Rent inflation has been falling since the start of the pandemic. So it has helped to keep a lid on overall consumer price inflation. Rent disinflation has offset price increases resulting from the stimulative monetary and fiscal policies implemented by the government to shore up the financial system and to revive economic growth. So far, rent disinflation has provided a headwind for overall inflation.

However, a shortage of houses for sale combined with rapidly rising home prices and mortgage rates could soon boost rent inflation, providing a tailwind for overall inflation. Consider the following:

(1) Housing market. The pandemic triggered a wave of deurbanization. City dwellers, especially those renting apartments, suddenly decided it was time to buy a house in the suburbs. They wanted big yards with swimming pools for their kids, home offices, and more distance from their neighbors. At the same time, the Fed’s ultra-easy monetary policies caused mortgage rates to fall to record lows. That only stoked demand for houses.

During the lockdowns at the start of the pandemic, the sum of existing plus new single-family homes plunged from 5.83 million units (saar) in February 2020 to 4.35 million units in May (Fig. 1). As the lockdown restrictions were lifted, home sales soared to a high of 6.98 million units during October, the best reading since April 2006. They remained around that pace through January.

The problem is that the inventory of existing and new homes for sale fell to a record low of 1.19 million units during January (Fig. 2). Demand is seriously outstripping supply. So home prices are soaring. The median and average prices of existing single-family homes rose 14.8% y/y and 12.3% y/y through January to fresh record highs (Fig. 3). Median home prices are up at double-digit rates in the Northeast (18.4%), West (17.5), Midwest (15.1), and South (14.7) (Fig. 4).

The backup in bond yields has caused the 15-year fixed-rate mortgage yield to rise from a record low of 2.32% on January 4 to 2.54% on Friday (Fig. 5). It’s likely to keep rising along with bond yields. The combination of low inventories of homes, soaring home prices, and rising mortgage rates may already be weighing on mortgage applications to purchase homes (Fig. 6).

Building a new home has become more expensive as lumber prices have soared (Fig. 7). We’ve heard that many builders are so busy that they tell prospective new homebuyers that they won’t be able to start on their projects for 12-18 months.

(2) Rental market. In other words, the lack of availability and the declining affordability of homes could convince urban dwellers to stay put in their rental apartments. For now, some might be able to negotiate a better rental deal with their landlord. However, the rental market could tighten later this year if the availability and affordability of homes discourages would-be homebuyers.

The inflation rate of the CPI for tenant rent fell to 2.1% y/y during January, down from 3.8% a year ago (Fig. 8). Following the Great Financial Crisis (GFC) of 2008, tenant rent inflation plunged to a low of -0.1% during May 2010, down from 4.6% during March 2007.

During the GFC and for a few years following this calamity, there was a glut of distressed homes for sale. Home prices fell, and so did rents. The Great Virus Crisis boosted the demand for homes and their prices, sending rent inflation downward. But rent inflation may not have much lower to go and could be on the way up again later this year for the reasons discussed above.

(3) Rent in consumer prices. In the CPI, rent of shelter includes tenant rent and owners’ equivalent rent. The latter closely tracks the former. Rent of shelter accounts for 33.3% of the headline CPI, 41.8% of the core CPI, and 53.1% of CPI services. Rent of shelter accounts for 16.6% of the PCED, 18.8% of the core PCED, and 25.3% of PCED services.

(4) Phillips curve. Fed officials seem to be running monetary policy under the influence of the notion that the Phillips curve is dead. It wasn’t too long ago that they believed that inflation is inversely correlated with the unemployment rate. The only question in their minds was whether this relationship had flattened in recent years given that record-low unemployment prior to the pandemic wasn’t heating up inflation after all, as they previously had feared.

Now Fed officials believe that they should continue to overheat the economy with monetary policy to achieve maximum employment by next year; yet any pickup in inflation will be transient. I tend to agree with them. However, for the record, there still is an inverse relationship between the jobless rate and the inflation rate of rent of shelter in the CPI (Fig. 9). Furthermore, there is a direct relationship between wage inflation and rent inflation (Fig. 10).

During February, the unemployment rate remained high at 6.2%. However, average hourly earnings rose at a fast pace of 5.3% y/y during the month. We’ve previously suggested that generous government unemployment benefits are keeping people from seeking jobs, resulting in labor shortages. That would explain why wage inflation might remain high. If so, then that could soon cause rent inflation to stop falling and start moving higher. The headwind for overall inflation could turn into a tailwind!

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