Here’s why housing inflation may take a while to cool down

An open house flag is displayed in front of a single family home on September 22, 2022 in Los Angeles, California.

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There are signs that inflation could fall further in the coming months, but the housing market threatens to dampen any improvement.

The consumer price index, a key indicator of inflation, rose 7.7% year-on-year in October. This annual reading, while still fairly high by historical standards, was the lowest since January.

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The monthly increase was also smaller than expected – giving hope that stubbornly high inflation and the negative impact it has had on consumer wallets may be abating.

But housing costs rose 0.8% in October – the largest monthly increase in 32 years. That may seem contradictory at a time when many observers are saying the US is in a “housing recession.”

But housing inflation — at least as reflected in the CPI — is likely to remain elevated for several months to a year given its importance to household budgets and the intrinsic dynamics of rental and housing markets, economists said.

“As the housing market cools, this category will also weaken, but we may have to wait until next year before it significantly dampens headline inflation,” said Jeffrey Roach, LPL Financial’s chief economist.

Housing is the largest item of household expenditure

The US Bureau of Labor Statistics, which issues the CPI report, breaks the housing category into four components: rent, lodging outside the place of residence (e.g., hotels), tenant and household insurance, and the owners’ equivalent dwelling rent.

Rents and “owner-equivalent rents” are by far the most important.

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The latter tries to put homeowners on an equal footing with renters. It essentially mirrors what homeowners would pay themselves to rent their home, said Cristian deRitis, deputy chief economist at Moody’s Analytics.

Housing is the biggest part of spending for the average consumer. The overall CPI weight reflects the following: Accommodation accounts for 33%, the largest share of any category. Accommodation therefore has an outsized impact on headline inflation from month to month.

The category of accommodation has increased by 6.9% in the last year.

The rental and housing markets are cooling off

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Slowing demand has caused home and rental prices to fall or fall in many areas of the United States

According to Redfin, a real estate broker, US home registrations this month through Nov. 6 fell 17.5% from the same period last year. The typical selling price of $359,000 was down over 8% from its June peak of $392,000, according to Redfin.

Mortgage demand has eased as interest rates have risen steadily to a recent high of over 7%, despite a sharp fall in interest rates last week.

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Meanwhile, rental inflation has slowed in 2022 from its breakneck pace last year, Zillow data suggests.

Americans paid an average market rent of $2,040 as of Oct. 31, according to the seasonally adjusted Zillow Observed Rent Index.

This rental price increased by 0.31% compared to the previous month, on September 30th. But the pace of that growth has slowed for four straight months. In comparison, rents were up about 1% in the month from late May to late June. Rent inflation hit 2% monthly in July and August 2021, according to Zillow data.

Why accommodation prices are lagging behind

The CPI for Shelter has historically lagged home price changes by four quarters, suggesting that shelter “will continue to exert upward pressure on headline inflation into the first half of 2023,” deRitis said.

The lag effect is largely due to how long it takes for leases to transition into a new contract. Landlords typically renew leases every 12 months, meaning current price dynamics are not reflected in new contracts for a year.

In that sense, housing is somewhat of an outlier among other CPI categories. For example, consumers are not willing to pay the same price for chicken or eggs for a whole year.

“Housing has some unique aspects,” said deRitis.

And rent tends to be “sticky,” according to economists — meaning total monthly rent dollars don’t generally go down; it tends to stay the same or increase with each new lease.

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