With the current economic climate, there’s no doubt that inflation is on everyone’s mind. The Bureau of Labor Statistics (BLS) has been surveying renters and homeowners to measure housing inflation, which is specific to the cost of housing. Interestingly, shelter inflation accounts for about one-third of the overall inflation rate measured by the Consumer Price Index (CPI). Recently, shelter inflation has been decreasing for the last four consecutive months, indicating a possible drop in overall inflation. In this blog post, we’ll explore the relationship between housing inflation and overall inflation and its impact on the economy.
The Consumer Price Index (CPI) is used to measure the changes in the prices of a variety of goods and services households buy. This index measures the average price changes over time for a basket of goods and services, including but not limited to food, housing, and healthcare.
Although shelter inflation accounts for one-third of CPI, it has a significant impact on the overall inflation rate. Due to the high cost of housing, a decrease in shelter inflation typically slows down inflation in other areas.
The Federal Reserve (the Fed) has been raising the Federal Funds Rate to control inflation since early 2022. As inflation rates climbed, the Fed responded by raising the Federal Funds Rate to keep the economy from overheating. This interest rate has a significant effect on the cost of borrowing money for banks. If the cost to borrow money increases, then consumers have less incentive to spend. In contrast, rising inflation encourages spending as consumers hurry to purchase consumer goods before prices go up, sending the economy into overdrive (it peaked at 8.9% in the middle of last year).
The moderate drop in shelter inflation could significantly affect the overall inflation rate and help the Federal Reserve achieve its 2% inflation goal (the latest report is 3.3%). However, the decrease may not be sustainable in the long term. Housing inflation is subject to many factors, such as supply and demand, and rental rates, which can change quickly.
Another factor that can cause housing inflation to surge is the surge in demand for housing. With the rise in remote work and the possibility of working from home, renters and homeowners are choosing to relocate to more affordable areas while still earning metropolitan salaries. This could result in high demand and premium prices for housing in certain regions.
The graph below shows the relationship between the two. Each time inflation (shown in the blue line) starts to climb, the Fed raises the Federal Funds Rate (shown in the orange line) to try to get it back to their target of 2% (see below):
The graph’s circled area highlights the most recent inflation spike, the Federal Reserve’s response by raising the Federal Funds Rate, and the subsequent decline in inflation. The Federal Reserve may not have to raise the Federal Funds Rate by much more as inflation approaches its target of 2% at the moment.
So, what does all of this mean for you? While the actions coming out of the Fed don’t determine mortgage rates, they do have an impact. As Mortgage Professional America (MPA) explains:
“. . . mortgage rates and inflation are connected, however indirectly. When inflation rises, mortgage rates rise to keep up with the value of the US dollar. When inflation drops, mortgage rates follow suit.”
Overall, the relationship between housing inflation and overall inflation is a significant part of the economy. Shelter inflation has a significant impact on the determination of inflation rates, as it accounts for one-third of the Consumer Price Index. The recent drop in shelter inflation could signify a rise in the inflation rate’s moderation in the coming months, a relief for many following the recent surge in the economy. Nevertheless, it is important to note that housing inflation is subject to many factors such as supply and demand, and the rental rate, all of which could change in the long term. The Federal Reserve’s interest rates related policies are effective in controlling overall inflation rates; however, it’s important to analyze housing inflation and other critical factors when exploring economic trends.
