Key indicator for the Fed's interest rate cut decision: Rent prices!

The "last mile" of the Fed's anti-inflation battle is being choked by rent.

Recently, an article by Nick Timiraos, a journalist from the "New Fed Communication Agency" known as The Wall Street Journal, pointed out that high rents are hindering the Fed's anti-inflation efforts.

The article explains that housing inflation accounts for one-third of the CPI index and one-sixth of the PCE price index, making it have a significant impact on overall inflation. Within housing inflation, while house prices are influenced by investment factors, rents are more reflective of the real market conditions, making the latter more crucial.

Timiraos stated in the article that the significant surge in rents during the pandemic has largely driven up inflation. Currently, rental inflation remains at a high level but is showing a downward trend.

During the pandemic, with strong demand and income, and historical low housing inventory, newly signed rental indices surged at one point. Data shows that in 2022, rents for single-family homes (the mainstay of American housing) rose by 14%.

Subsequently, new apartment constructions diverted strong demand from the single-family home market, income growth cooled after adjusting for inflation, and rents for single-family homes began to decline.

Since most tenants' rents only change once a year, the manifestation of new lease rents lags behind. Based on existing market rental data, Fed officials, Wall Street investors, and private sector economists believe that housing inflation has slowed down since the end of 2022.

This year, the "stagnant" inflation data, especially core inflation, does not seem to affect the Fed's plan to cut interest rates this year. The article explains that the Fed is confident that housing costs will eventually slow down and drive inflation down to 2%.

As previously mentioned by Wall Street News, Steven Englander, Chief Foreign Exchange Strategist at Standard Chartered Bank, recently reported that by closely monitoring housing costs, especially housing inflation-related indicators in the CPI such as Owner's Equivalent Rent (OER), there are reasons to be optimistic that housing inflation may soon decline and drive down core inflation.

This Wednesday, the U.S. Bureau of Labor Statistics will release the CPI for April. Currently, economists generally predict that the year-on-year CPI for April will slightly decrease from 3.5% last month to 3.4%, and core CPI will also decrease from 3.8% to 3.6%.

How much does rental inflation need to decrease?

Since slowing down rents is crucial to lowering the core inflation rate to the Fed's target, how much does rental inflation need to decrease?

Breaking it down, the article divides core inflation into three sub-items: goods inflation, housing inflation, and non-housing service inflation.

The article points out that before the pandemic, goods inflation was around -1%, housing inflation was around 2.5%-3.5%, and non-housing service inflation was slightly above 2%—resulting in an overall core inflation rate slightly below 2% Therefore, to bring the inflation rate back to the 2% level, the non-housing services inflation rate must drop from the current 3.5% to below 3%, and the housing inflation rate must drop from 5.8% to around 3.5%.

The Last Mile is Not Easy

However, some views suggest that the outlook for rental inflation is not as optimistic.

The article points out that many economists believe that the downward trend in new lease rental rates in recent years will indeed cool down housing inflation, but this process may take longer than imagined. Timiraos explains:

"Due to the impact of high interest rates, the willingness of more households to buy homes is low, and there is higher demand for lease renewals. This may prolong the time needed for the decline in new lease rental rates to be reflected in overall inflation."

Another significant risk is that new apartments are also facing a supply-demand imbalance.

Wall Street News has previously mentioned that compared to apartments, housing inflation is more susceptible to the impact of single-family home rents, as the latter is the mainstay of U.S. housing. One important reason for the recent slowdown in rents is the rapid increase in the supply of new apartments, diverting strong demand for single-family homes.

However, the article points out that some industry executives have stated that due to immigration growth, as well as steady growth in employment and wages, demand for new apartments is picking up again, which could lead to a resurgence in the single-family home market.

According to data from real estate company Camden Property Trust, the current proportion of tenants leaving its apartments has dropped to 9%, the lowest level in the company's 30-year history. Typically, a normal turnover rate is at the level of 15%-18%.

The company's CEO, Ric Campo, stated:

"The reality is that demand is much higher than most people expected."