MNI INTERVIEW: Housing Inflation To Fall Slowly-Fed's Mehrotra

MNI (WASHINGTON) - Slower U.S. rent growth for new leases is likely to take some months longer to work its way through CPI housing data, while uncertainty over whether housing inflation will return to pre-pandemic levels raises concern about the persistence of overall inflation, Neil Mehrotra, an economist at the Federal Reserve Bank of Minneapolis told MNI.

New lease rent trends filter through to CPI measures more slowly than previously thought – with a lag of about 19 months, according to new research from Mehrotra and co-author Alisdair McKay. That means the contribution of housing to overall inflation will stay outsized well into 2025. 

"In 2023 we thought shelter inflation would come down and normalize at pre-pandemic levels by the second half of 2024. That hasn’t really yet materialized," Mehrotra said in an interview. "I see shelter inflation as continuing to ease over the rest of the year, but it’s going to be pretty slow and that will continue to affect the headline and core CPI."

If housing inflation ultimately plateaus at a level higher than before Covid, then further disinflation will need to come from goods or nonhousing services for the Fed to hit its 2% inflation target, he added. 

"Policymakers have to be at least cognizant of the fact that this time might be different, and CPI shelter might not get all the way back. If you don't get CPI shelter all the way back, then getting inflation back to 2% requires you to get some place lower with the other components of core inflation."     

PRICE CATCH-UP

U.S. shelter costs rose 0.4% in July, accounting for nearly 90% of the rise in the consumer price index. On a 12-month basis it has stayed north of 5%, compared to 3.3% on average in the 2016-2019 period. Headline and core CPI were 2.9% and 3.2%, respectively, last month.

Rents for new leases are seen as a leading indicator for the shelter categories of CPI. The Zillow Observed Rent Index began accelerating rapidly at the end of 2020 and housing CPI followed. But as market rents measures peaked and normalized over a 12-month period from mid-2022 to mid-2023, housing CPI still runs hot. 

Mehrotra and McKay calculated the rate at which leases reset to the market rent (as measured by Zillow and the Bureau of Labor Statistics New Tenant Rent Index) and found it takes nearly two years for contract rents to catch up with market rents. The peak in market rents was much higher than that of housing CPI – 16% versus 8%. 

"So if you think the level of prices has to catch up in the long run, then it means a longer period of time that CPI shelter has to be relatively high to catch up to the level of market rents," he said. 

WAITING

If shelter inflation were at pre-pandemic levels, core CPI inflation would be close to 2% now, Mehrotra said. But if his model is correct and housing CPI remains above 5% through year-end, "that’ll have a material effect on core CPI, keeping it close to 3% or in the high 2s," he said. 

"This is something I think many policymakers are worried about. We have these market rent measures. We don’t know how well they capture what the BLS measure captures. We think the Zillow measure is a forward-looking measure for CPI, but precisely how big a difference can be sustained – shelter CPI at 4.5% is very different from 3.5% and that has a meaningful effect on overall core inflation." (See: MNI: Fed Seen Sticking To 25BP Cut In Sept Post-CPI- Ex-Staff) 

The Fed's preferred inflation measure, the PCE price index, places a smaller weight on shelter, so the contribution of shelter to the PCE is smaller, Mehrotra noted. Core PCE would be 0.4 pp lower if shelter inflation returned to pre-pandemic levels. 

"For core PCE, it has less of an impact, but it's still noticeable."