Rent Declines Have Already Solved the FOMC’s Inflation Problem

The continuing interest-rate increases from the Federal Open Market Committee (FOMC) are designed to achieve one crucial result: bring inflation down to a long-term average of about 2 percent. The goal of these increases is important: to avoid allowing high inflation to become embedded in long-term inflation expectations, which could trigger a wage-price spiral that would be difficult to end. There is, however, an equally important risk associated with interest-rate hikes: if they extend too long or too far, they could cause the economy to overshoot the inflation target and fall into recession.

Real-world data shows that the economy may already have reached the Fed’s inflation target—but the Consumer Price Index (CPI) may fail to show it for many months, raising the possibility that the Fed’s interest-rate hikes may go too far. The problem is that the CPI and the government’s other inflation measure (the Personal Consumption Expenditure, or PCE, deflator) use a measure of rent inflation that lags dramatically behind what new renters are actually paying when they sign a lease. And measured rents drive one-third of the CPI, so the measurement problem is a really big one.

As measured in the CPI, rents have continued to drive up the overall inflation rate even while other components of inflation have declined sharply. In fact, the annualized increase in the shelter third of the CPI over the last two months was a stunning 9.6%, while the other two-thirds of the CPI increased by a paltry 1.0% (annualized). In other words, over the past two months essentially all of the country’s inflation has been driven by the way the CPI measures rents.

Meanwhile, what’s happening in the real world? Rent increases have not only declined dramatically—but they seem actually to be falling, at least for new renters. Rental housing operators guard their actual data, but several sources have reported on the market-wide decline in rent growth. Data published by researchers at Penn State University say that since June 2022 there has been a growing divergence between rents in the real world and rents as they are measured officially: in fact, the Penn State data show that rents have actually declined over the past two months—and, as a result, the overall inflation rate has actually been increasingly negative.

The Penn State/ACY Alternative Inflation Rate measures inflation in new (marginal) rents, and then estimates what the overall inflation rates would be if the CPI and the PCE deflator incorporated new-rent inflation instead of the lagged measure actually applied. The Penn State researchers say that new rents have declined by -3.3% over just the past two months—a stunning annualized decline of -18.1%.

Taking into account this huge decline in new rents, the Penn State/ACY Alternative Inflation Rate suggests that the CPI would have actually declined by -1.0% over the last two months (-5.8% annualized) while the “core” CPI would have declined by -1.3% (-7.3% annualized). The PCE deflator—which the FOMC generally calls its preferred measure of inflation—would have increased over the same period, but by a paltry 0.2% over the last two months, annualizing to just +1.2% for overall inflation and just +1.4% for core inflation.

In other words, after correcting for problems in the way new-rent inflation is measured for the CPI and the PCE deflator, overall inflation has already fallen to well below the FOMC’s long-term target.

Does this mean that interest-rate hikes are over? Hardly. In fact, it seems almost predestined that the FOMC will raise rates again in March, and very likely that there will be more rate hikes after that. That’s not necessarily a bad thing. After all, overall macroeconomic conditions seem strong enough to absorb higher interest rates, and holding interest rates near zero—as our country has done for most of the time since 2008—typically distorts investment incentives in ways that hurt in the long run. On top of that, consumer surveys conducted by the University of Michigan and the New York Fed suggest that there is still a very high danger of high inflation becoming embedded into high inflation expectations and triggering a damaging wage-price spiral.

In other words, there are very good reasons for interest-rate hikes to continue. But the most important one—the battle against actual inflation—may already be over.

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