MNI INTERVIEW: Hot US Labor Market To Keep Rent Inflation High

The rate of U.S. housing services inflation will likely settle higher than before the pandemic and potentially contribute 2.5 percentage points to core CPI for as long as the labor market stays tight, nearly twice as much as pre-Covid, Kansas City Fed economist A. Lee Smith told MNI.

Rent inflation has been on a steady climb since 2021 and is already the largest contributor to elevated core inflation. While Fed officials are expecting a reversal in the second half of the year, citing falling market rates on new leases, new research by Smith and colleagues at the Kansas City Fed shows housing disinflation may be limited, because rents are sensitive to measures of labor market tightness, as are other core services components like health care and hospitality.

"Our view is that the labor market will underpin demand for shelter. That was true pre-pandemic even as the acceleration in rents during the pandemic suggests other forces at play," such as a greater demand for space as people spent more time at home, Smith said in an interview.

"Once the dust settles on that, the labor market will be the driver of rent inflation going forward."

SLOW SUPPLY CHANGES

Housing services contributed half of the 6% core CPI in the fourth quarter, compared to an average of 1.5 pp when inflation was running near 2% percent before the pandemic. Shelter comprises 40% of the core CPI basket, though it's a smaller component of the Fed's preferred PCE price index basket.

Smith and his co-authors measured labor market tightness using the ratio of job vacancies to the number of unemployed workers and found both housing inflation and non-housing core services inflation respond to a tight labor market three times as much as core goods inflation.

Unlike non-housing core services, housing inflation is not labor intensive. Yet it is clear that "changes in demand for shelter largely shape rent inflation over economic cycles," Smith and his co-authors wrote.

"If you do a back-of-the-envelope calculation, if the tight labor market persists, the contribution of housing services to core CPI could remain near 2.5 pp on an ongoing basis, which would be considerably higher than the 1.5 pp contribution pre-pandemic," Smith said.

MORE SIGNS

Supply-side shifts in housing are too slow-moving to have much of an effect, Smith added, even as the pandemic housing boom will deliver more new-construction multifamily units this year than at any time since the 1980s. New supply tends to be higher-end luxury homes, Smith said, and "that could limit the extent to which it will lower overall rent inflation."

There are other reasons to think a return to pre-pandemic rates of rent inflation could prove elusive.

The Zillow rent index, a measure of what landlords are asking on new leases, has climbed about 27% since December 2019 while the Labor Department's rent index has increased just 15%. "If you think that gap has to close somehow, then there is scope for the Zillow metric to undershoot BLS rent inflation for some time," Smith said.

Additionally, consumers’ expectations of rent inflation moved up significantly last year, according to the annual New York Fed housing survey. Households on average last year expected rent increases of 11.5% over the next twelve months, compared with 6.6% a year earlier. Over the next five years, they saw annual rent increases of 5.2%, up from 4.4% in 2021. An update for 2023 is expected in April.

"If consumers are already expecting increases, there will be little resistance when landlords ask for those increases,” Smith said.