The Housing Inflation Storm

Main Takeaway: Housing inflation is sticky and means that until we see a major injection of rental and housing supply hit the market, this core component of inflation will remain elevated. Although price decelerations are already occurring, the persistent supply shortage will keep us from a deep crash in the market.

Story:?Shelter costs make up about a third of the Consumer Price Index (CPI). For homeowners, the cost of housing in the CPI is called the Owners Equivalent Rent of Residences (OER), which shows, on average, how much someone would pay if they had to rent a home like their own. For renters, the cost of rent and utilities are used to measure shelter. Further, other sectors of the economy affect shelter costs such as commodities like lumber.

The reality is that shelter costs remain persistently high and are lagging indicators which means it will take time before they come back to reality. Here are the?latest shelter numbers?from the U.S. Bureau of Labor and Statistics:

In all, housing inflation is a significant component of the Fed’s calculus on interest rates. The problem is, these measures are lagging. And, according to the?Federal Reserve Bank of Philadelphia, the primary solution is?increasing supply. However, this is not something the Fed can solve. Federal, state, and local governments must encourage more buildings if we are hoping for any reprieve in shelter inflation. According to the bank:

Perhaps the most effective reform to incentivize affordable home building would be to revisit zoning laws. In many communities across the country, zoning laws prohibit the construction of multifamily units. Seattle, for instance, is largely zoned for single-family homes. This has undeniably produced a city full of quiet, charming neighborhoods, and one can certainly understand some local resistance to loosening zoning.?

As we’ve?discussed, decision-makers are wising up to the reality that zoning changes are critical to improving the housing supply. Here are a few examples:

• Oregon?— Portland?upzoned?most of its city, allowing for 2-4 units on what were previously single-family lots. Planners now estimate that this will add 4,000 new units over the next 15 years.?
• California?— SB9 was?passed?last year in the state allowing for almost all R1 zoned lots to now, by legal right, have up to 4 units on them under certain guidelines. That is, a single-family home can now be converted into a triplex, for instance, without having to go through time-consuming and expensive rezoning applications.
• New Hampshire?— The state legislature is?debating?a bill that would allow, by right, single-family homes and lots to subdivide up to four units. This basically overrides existing single-family zoning in what is typically called ‘inclusionary zoning’.?
• Florida?— Gainesville?became the first city?in the state to ban “exclusionary zoning” which only allows for one building on one lot. This paves the way for lighter densification in the form of ADUs, duplexes, and triplexes.

Further, in May, the White House?released?its new?Biden-Harris Administration Housing Supply Action Plan?aimed at helping improve the supply gap. The plan, among other initiatives, aims to “reward jurisdictions that have reformed zoning and land-use policies with more grants.” And more jurisdictions will follow suit.

This issue here is that until supply eases, shelter costs will remain elevated, supporting high inflation numbers. Exacerbating the supply crunch is that many homeowners have a low 30-year fixed, that they obtained over the last decade. With such a low rate, the incentive to move or sell is highly diminished, taking much-needed supply off the market. This will be particularly painful for first-time homebuyers, who will be increasingly forced to rent.

Indeed,?according?to Christopher Rugaber of the Associated Press:

Yet prices for services — particularly rents and housing costs — are remaining persistently high and will likely take much longer to come down…But the government’s measure tracks all rent payments — not just those for new leases — and most of them don’t change from month to month. Economists say it could be a year or longer before the declines in new leases feed through to government data.

This push to rentals will also keep supply tight on that side of the market, and until the feedback loop on new construction catches up with demand, expect housing inflation to remain elevated for the foreseeable future.

Expert Take

“High housing inflation is a macroeconomic problem; money spent on housing is money not spent on education, durable goods, or meals out. And shelter inflation will eventually degrade the economic performance for the most costly areas as well. There is already evidence that the most expensive metro areas are not achieving their full economic potential because millions of would-be participants simply can’t afford to live there.” —?Patrick T. Harker, President and Chief Executive Officer of the Federal Reserve Bank of Philadelphia

Chart: New Construction to the Rescue

According to new?Redfin?data, 29% of homes for sale in Q3 were new construction, a record high. This however may be partly due to the resale market being at record lows due to the factors noted above.

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