By Lisa Sturtevant, PhD
Chief Economist, Bright MLS
Inflation has not just stalled—but it is moving in the wrong direction, according to the Bureau of Labor Statistics’ report on the Consumer Price Index (CPI). Headline inflation was at 3.5% in March, up from 3.2% in February. This is the second month in a row of increasing inflation and is the biggest jump since August.
What does this mean for interest rates?
While inflation is down from the high of 9.1% in June 2022, it's not down far enough for the Federal Reserve to start cutting interest rates. The Fed is looking for core inflation to be at 2% before lowering the federal funds rate. The rationale is that prices are increasing too fast because demand is still too strong, and higher interest rates are needed to cool that demand and bring prices down.
In these strange economic times, the rules may not apply.
We could be a long way from a 2% inflation rate—and even when we get there, it might not actually be 2%. Housing—or shelter, in CPI vernacular—accounts for the largest portion of the CPI. The annual rent inflation in March was 5.7%, unchanged from last month and still high enough to help keep inflation elevated.
Rents have been coming down in many parts of the country as record levels of new apartments were delivered in 2023. However, data on rents enter the CPI calculation with a lag—sometimes by as much as 12 to 18 months. So, we might not see the effect of lower rents in the CPI until this summer or fall, which means hitting a 2% target won’t be possible until at least then.
It's a bit of a shell game.
We’ve already seen rents in the real world begin to increase and new apartment construction as measured by new building permits has slowed considerably. By the summer or fall, just when lower rents are entering the CPI calculation, actual people out there looking to rent a home could very well find rents higher.
If the Federal Reserve waits until lower rents enter the CPI calculation and brings core inflation down to 2%, it will mean interest rates remain higher for longer. But ironically, higher interest rates suppress housing supply—the very thing needed to bring housing costs down.
Bottom line: Waiting for that 2% target to lower rates is risky.
The Federal Reserve is very much aware of the implications of the shelter component of the inflation measure. Knowing the shelter costs are keeping inflation artificially high should give the Fed more room to move on rate cuts earlier. The CPI minus shelter stood at 1.9% in March, the sixth month in a row below 2%.
By sticking hard-and-fast to its inflation target, the Fed risks waiting too long to lower interest rates and is not taking into account the particular way in which the housing market is driving inflation.
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