Over the past two years, inflation has been one of the most pressing economic concerns in the United States and across the globe. Rising prices for goods and services, from food and energy to transportation and housing, have affected households, businesses, and policymakers alike. While recent data suggests that inflation is mostly under control, there’s one area that continues to pose a stubborn challenge: housing prices. As the Federal Reserve prepares for its upcoming policy meeting, the spotlight remains on shelter costs and their significant impact on the broader inflationary landscape.
This article delves deeper into the backstory of inflation, the long-term implications of the current housing market, and how the Federal Reserve’s policies may evolve in response to these economic pressures.
A Brief History of Inflation and the Fed’s Response
To understand where we are today, it’s essential to revisit the roots of the current inflationary cycle. In the wake of the COVID-19 pandemic, unprecedented government stimulus measures, supply chain disruptions, and a rebound in consumer demand contributed to a sharp rise in prices. The Consumer Price Index (CPI), the most widely followed gauge of inflation, surged to levels not seen in decades. Energy prices spiked, food costs climbed, and shortages of key materials like semiconductors led to price hikes across various sectors.
The Federal Reserve, which is responsible for maintaining price stability and maximizing employment, responded by raising interest rates at a historically fast pace, aiming to cool inflation. From near-zero rates in early 2020, the Fed has gradually raised rates to the highest levels since the 2008 financial crisis. While these aggressive moves have had a dampening effect on many inflationary forces, notably in energy and consumer goods, housing prices remain a major obstacle in the inflation battle.
The Housing Market’s Unique Role in Inflation
Housing plays a unique role in the inflationary equation, both in terms of its direct impact on the cost of living and its weight within the CPI. Shelter prices, which include rent and owners’ equivalent rent (OER), account for a significant portion of core CPI, which excludes more volatile categories like food and energy. This means that even as other categories experience price relief, high housing costs can keep core inflation elevated.
In the latest CPI report, shelter prices accounted for more than 70% of the gain in core inflation over the past 12 months, underscoring the extent to which housing is driving inflationary pressures. According to investment firm Brean Capital, core CPI would have risen just 0.1% in August if shelter prices were excluded. This illustrates how the broader inflation picture would look far more favorable if not for the ongoing strain in the housing market.
So, why is the housing market so persistently tight?
The Roots of the Housing Crisis
The housing market’s current state is the result of a confluence of factors that have been building for over a decade. The 2008 housing crash led to a significant slowdown in new home construction, and it took several years for builders to ramp up production again. Meanwhile, as the population grew and demand for homes increased, the supply of available housing struggled to keep pace.
The COVID-19 pandemic only exacerbated these issues. With remote work becoming more common, many families sought to move from urban centers to suburban and rural areas, driving up demand in previously affordable markets. At the same time, supply chain disruptions delayed new construction, and a lack of labor in the construction industry further hindered the ability to build new homes quickly enough to meet demand.
Compounding the problem is the increasing financialization of the housing market, where large institutional investors, such as private equity firms, have bought up single-family homes to rent out, further reducing the supply of homes available for purchase by everyday Americans. These dynamics have kept prices high, even as other inflationary pressures have eased.
The Current State of the Housing Market
Today, the housing market remains tight, with too many would-be buyers and renters chasing too few homes. According to the latest CPI report, rent prices and owners’ equivalent rent rose 0.5% in August, the fastest monthly gain since January. This acceleration in housing costs has offset progress in other areas of the economy, keeping overall inflation higher than it otherwise would be.
Morningstar senior U.S. economist Preston Caldwell recently noted that “housing is the sole remaining driver of our inflationary worries.” This sentiment was echoed by White House economists, who in a blog post attributed the ongoing pressure on housing to “the very tight housing market and the decade-in-the-making shortage of affordable housing.”
The Federal Reserve’s Dilemma: Balancing Inflation and the Labor Market
The Federal Reserve faces a difficult balancing act as it prepares for its next policy meeting. On the one hand, the overall inflation picture has improved significantly. Headline CPI rose just 0.2% in August, matching the previous month’s increase, while core CPI increased 0.3%, up slightly from the prior month but still within a range that suggests inflation is moderating.
Over a shorter time horizon, even core inflation looks more controlled. On a three-month annualized basis, core inflation rose 2.1%, which is right around the Fed’s 2% target. If not for the stubbornly high shelter costs, inflation would likely be at or even below the Fed’s desired level.
Yet the labor market adds another layer of complexity. While inflation has cooled, the job market remains tight, with unemployment still near historic lows and wage growth outpacing inflation in some sectors. The Fed is increasingly concerned about the potential for a wage-price spiral, where rising wages push prices higher, which in turn leads to further wage increases. As such, the Fed’s policymakers may hesitate to cut rates too aggressively for fear of reigniting inflation, particularly if housing prices remain elevated.
The Fed’s Likely Path Forward
In this context, the Fed is expected to approach its next policy moves with caution. While some analysts had anticipated a larger rate cut, the latest CPI report suggests that a smaller, quarter-point cut is more likely. As Seema Shah, chief global strategist at Principal Asset Management, wrote, “The hawks on the committee will likely seize on Wednesday’s CPI report as evidence that the last mile of inflation needs to be handled with care and caution.”
A more aggressive half-point rate cut, which some market participants had been speculating about earlier in the week, now seems off the table. The CME FedWatch tool shows that the odds of such a move have fallen dramatically, from 34% on Tuesday to just 15% after the CPI report’s release.
However, the Fed’s decision-making process will extend beyond just inflation data. The labor market, global economic conditions, and financial stability considerations will also factor into their calculus. While the Fed is unlikely to make any dramatic shifts in policy in the near term, the ongoing housing crisis ensures that inflation will remain a key focus for policymakers in the months to come.
Long-Term Implications: The Housing Market’s Lasting Impact on the Economy
Even as the broader inflationary pressures recede, the housing market’s challenges are likely to persist for years to come. Without a significant increase in housing supply — which will require both private sector investment and government intervention — affordability will remain a major issue for millions of Americans.
This has profound implications not just for inflation, but for economic inequality and social mobility. As housing costs continue to rise, low- and middle-income families are increasingly priced out of desirable areas, limiting their access to good jobs, quality schools, and other opportunities. This, in turn, exacerbates wealth inequality and stifles economic growth.
Moreover, as housing affordability becomes a central issue for voters, it could reshape the political landscape. In the upcoming election cycle, affordable housing is likely to be a top priority for candidates, and the pressure on policymakers to address the housing shortage will only grow.
Conclusion: The Inflation War’s Final Frontier
The war on inflation may be largely won, but the battle over housing prices is far from over. As the Federal Reserve weighs its next move, housing costs will remain a critical factor in determining the future path of inflation and interest rates. While the broader inflation picture looks favorable, the housing market’s persistent tightness ensures that inflationary pressures won’t fully disappear anytime soon.
For the Fed, this means walking a tightrope between cooling inflation and maintaining economic stability. For policymakers, businesses, and families alike, addressing the housing crisis will be essential to ensuring a stable, prosperous future.