Headlines surrounding the Fed are focusing on inflation stemming from tariffs and the weaker job market. After all, that has been what FOMC officials have mostly commented on, and it correlates with the Fed’s dual mandate. But the housing market could be the primary driver of a shift in the Fed’s policies.
The shelter component of inflation accounts for approximately one-third of the price change and is the fastest-growing element within the CPI basket. June CPI was reported at 2.7%, but shelter prices rose 3.8%. Shelter is also included in the core rate, which is more closely monitored by the Fed, where it has an even greater impact, as food and energy account for over 20% of household spending.
The Theory and the Practice
Usually, the rate of change in housing is pretty stable. Therefore, it’s reasonable for Fed officials in normal circumstances to expect a shift in consumer prices to come from elements that are more likely to change and are being subjected to social, political, or economic pressures. The fact is, Fed policy has a significant impact on the housing market because it sets the benchmark interest rate. With higher interest rates, it becomes more expensive to buy houses, depressing the market.
Housing prices are not significantly affected by tariffs. Although some elements of new houses could be affected by import prices, the vast majority of housing is already built in the country. With the Fed essentially stating that the primary reason to keep rates high is to prevent tariffs from causing inflation, it’s natural to overlook the housing market. But that doesn’t mean there aren’t signs that shelter prices might fall substantially in the near future.
The Weak Housing Market
Ever since the Fed ramped up interest rates in the wake of covid, the housing market has been depressed. Approximately 1 million fewer homes are being sold each month compared to before the pandemic. There are multiple factors, but high interest rates are playing a key role. People are unwilling to put their existing home on the market because they cannot afford to buy a new one at a comparable interest rate.
The lack of supply has pushed prices higher, not an excess of demand. Higher interest rates, therefore, are unlikely to resolve this problem. They would make it worse, in fact. This could be one reason why US President Donald Trump is pushing so hard to lower rates.
Inflation Trumps Labour Markets
The weakness in hiring has given some analysts hope that the Fed might cut rates in response to a loosening labour market. Powell has even hinted at that, since lower wage growth usually translates into less inflation. However, the Fed focuses not on the number of people hired, but rather on the unemployment rate. With the White House’s aggressive actions to deport migrant workers, this could mean the jobless rate remains low. It also means a weaker demand for housing.
On the one hand, this could mean that the job market won’t push the Fed to lower rates. On the other hand, it could create a perfect storm for the bottom to fall out of the housing market. There is already weak demand, which is being masked by low supply. Delinquency rates (the number of people who can’t pay off their mortgages) have been rising steadily ever since the Fed raised rates, with only a brief pause after last year’s rate cuts. A sudden spike in credit issues could get the Fed’s attention and lead to another rapid easing spell. Just like last year when the deterioration in the labour market went unnoticed and the Fed cut by 50 bps to “catch up” to the data.
