The IMF on U.S. Housing Inflation: This May Persist For Some Time
Inflation returns. After 40 years of falling inflation to rates so low that central banks were concerned that it was too low, the rise in the last couple of years occurred with a magnitude and speed that was stunning. The causes have been studied and will continue to be for a long time. It is highly likely that there are multiple reasons, since inflation is so pervasive, affecting many categories of both goods and services. While the complexity of analyzing multiple markets makes the task more unwieldy, it is probably necessary, nonetheless.
It is also useful in thinking about the future because some of the categories that have contributed to rising inflation have already started to pull back. Used car prices were a leader in the inflation numbers, for example, but now show signs of retreating. Price elasticities of demand and supply. and the response of central banks, will likely attenuate the problem. But those effects will depend upon the category.
An important one is housing, which is a large expenditure for most households. The IMF recently looked at the prospects for housing costs in several countries, but particularly the U.S., which is our focus here. Their conclusion was that the contribution of housing to U.S. inflation is likely to be more persistent over the intermediate term than is consistent with the Federal Reserve’s 2% target.
Measuring housing costs is more complicated than it is for most categories of goods and services. Rents are fairly straightforward. They are specified in a lease contract between tenant and landlord, typically for one year. The government collects such information for the rent component of inflation.
Owner-occupied housing is more complicated since ownership confers the benefit of appreciation in price (or the risk of loss). That asset value is quite different from consumption goods and services. So the agency assembling the data (the Bureau of Labor Statistics, BLS) asks its sample of homeowners how much they would have to pay to rent their houses and uses that data, known as Owners’ Equivalent Rent (OER), as its proxy for the consumption portion of housing cost. The sample is taken every six months, since rents do not change frequently.
Contract rent and OER data are combined to produce the housing costs that are used in the inflation numbers. The two principal inflation series in the U.S. are the Consumer Price Index (CPI) and the Personal Consumption Expenditure Deflator (PCE) using weights established by the agencies that publish them, which are quite different (Chart 1):
The Federal Reserve uses the PCE series as its reference and its 2% target.
The Covid pandemic produced multiple chaotic outcomes, one of which was lifestyle preferences and accompanying shifts in housing demand that produced significant price increases. The IMF found that house prices led the housing inflation series:
House price growth appears to lead the Fed’s main target for monetary policy, PCE inflation, including during the early stage of the housing boom starting in the late 1990s, the housing bust during the GFC and the subsequent recovery, as well as the COVID-19 pandemic (Figure 2a). A similar relationship exists between the U.S. headline inflation and house price growth (Figure 2b).
The IMF also found that house prices appear to affect both components of housing inflation:
House price growth appears to lead the growth in the rent component of the headline inflation…Moreover, house price growth also appears to lead the growth in the OER component of headline inflation (Figures 3a and 3b):
With this historical data the IMF, assuming the lags they observed, built multiple models of the relationship between house prices and the related inflation series, and tested the results of each. They selected the model with the best statistical fit to forecast rent and OER inflation (Chart 4):
We have weighted each of these series by the weights in Table 1 to produce a composite that estimates the contribution of housing to CPI and PCE inflation over the IMF’s forecast horizon through 2023 (Figure 4):
This result is troublesome. The IMF’s modeling could turn out to be wrong, of course—any modeling of the economic future can be. But their work appears to be rigorous. It suggests that housing would be a persistent source of upward pressure on the overall inflation numbers in the intermediate term.
There is one large force that can act as a counterweight, and that is the Federal Reserve. Since March of this year, they have become increasingly aggressive in fighting pervasive inflation pressure. Those policies have already affected the housing market based upon recent readings, including the most recent monthly sales price data for existing homes.
It has long been understood that monetary policy acts with lags that are long and variable, and there are likely to be side effects that are negative. The Fed is resolute for now, but those side effects can be both material and unexpected. We have previously opined that the Fed’s 2% inflation target may be more difficult to achieve than is apparent (Pondering the Future of Two Percent, July 2022). The IMF’s statistical work suggests that housing will not make their task any easier.
Liu, Yang, Y, Di Yang and Yunhui Zhao, “Housing Boom and Headline Inflation,” International Monetary Fund Working Paper 22/151, July 2022.
John is a Senior Research Consultant and whose primary responsibilities include contributing differentiated macroeconomic perspectives as well as providing industry and company research.
In addition, he writes investment commentary, which is published on our website.
John has worked in the investment industry for over 45 years. He was formerly our Director of Research. Prior to joining BFS, he was the Chief Investment Officer at New England Asset Management, Inc.
John has achieved the designations of Chartered Financial Analyst® and Certified Public Accountant.
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