Macro Signposts | 21 February 2024

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Why Rent Levels May Not Drive Rapid U.S. Disinflation

Last week, the annual policy conference of the National Association for Business Economics (NABE) in Washington, D.C., hosted Fed and Treasury officials, along with hundreds of economists, analysts, and business leaders. I participated in a panel on the Fed's balance sheet, but the most intriguing takeaways came from conversations on the sidelines. What surprised me was the overwhelming consensus that rents would drive another rapid disinflation in the U.S. economy in 2024.

Key to this argument is the collapse in market rents in multifamily structures. Many economists at the conference suggested the Fed should already be considering rate cuts because this trend suggests inflation is headed sustainably toward the central bank's target.

As Macro Signposts regulars may guess, we think the outlook for inflation is more nuanced. We agree that inflation in owners' equivalent rent (OER) – the largest component of core CPI at 24% – will likely continue to moderate. However, its path is likely to be slower and "bumpier," like the unexpected jump in January OER, than many expect. We point to three reasons.

Important distinctions in measurement: markets vs. OER average
First, it's important to differentiate between measures of rents. Market measures of rent represent the marginal rent paid by the next renter. In contrast, OER reflects the average rent paid across a representative sample of units – including those that do not come to market.

This distinction is important: Although inflation in market rents – which has tended to lead OER inflation by around 1 year (see Figure 1) – has dipped below pre-pandemic levels, there still exists a relatively large 5%–10% gap between the levels of market and average rents (see Figure 2). In essence, most renters pay below-market rents due to locked-in contracts or capped increases. This gap should support OER inflation over time – and moderate OER inflation more slowly than if the gap didn't exist.

Figure 1: Market rent measures tend to lead OER

Source: U.S. Bureau of Labor Statistics (BLS) CPI OER data through January 2024; Zillow data through December 2023; CoreLogic data through November 2023

Figure 2: Single family home rents remain particularly high

Source: U.S. Bureau of Labor Statistics (BLS) CPI OER data and Zillow data through January 2024; CoreLogic data through November 2023. All measures are indexed to 100 in 2019.

According to 2023 research by Brian Adams of the Bureau of Labor Statistics (BLS) (et al.), published by the Cleveland Fed, only an estimated 10%–20% of the CPI rental sample is based on new tenant rents, implying that it may take 4 years at least before the average rents of the outstanding rental stock catch up to the new lease rents, assuming new lease rents don't rise further. Put another way, unless national market rents fall 5%–10% (which is unlikely outside a recession), non-market rents (and therefore OER) are likely to continue to be supported by landlords trying to "catch up" to market rates.

Single family rents remain firm
Second, rents of single family detached structures – the majority of the OER sample – are still much firmer than multifamily apartment units. This will tend to make OER inflation slower to moderate than the CPI "rent" measure, which is 8% of CPI, and where multifamily properties are a larger portion of the sample base. A 2020 paper¹ by Brian Adams and Randal Verbrugge found a high degree of rental market price segmentation, especially between single family detached housing and large multifamily apartment buildings. The findings were so conclusive that in January 2023, the BLS updated its OER sample² to better represent rental trends in the single family housing market.

Pandemic-related trends in housing markets increased the importance of the BLS's move to increase the weight of single family structures toward 90% (from around 50% previously). The wave of migration from city centers during the pandemic pushed up rents of single family homes by around 10 percentage points more than rents of multifamily structures, on a cumulative basis since 2019, according to Zillow.

More recently, rents in multifamily structures have declined as a large amount of supply has come to market, especially in cities across the sunbelt. And with more multifamily rental unit supply expected in 2024, the outlook for prices of multifamily structures is likely to remain subdued. Nevertheless, prices of single family detached structures appear generally more stable and above pre-pandemic levels, implying any OER inflation moderation will lag behind many predictions based on pre-2023 CPI rental sample weights.

These differences in rental trends between single family and multifamily also appear to be driving the underperformance in the BLS's "New Tenant Rent Index." The index collapsed in Q4 2023, leading some market commentators to argue that OER will soon follow. We aren't so sure. The measure has a relatively small sample size (which is even smaller in Q1, when few people change residences) of mostly multifamily units, which tend to turn over with new tenants more frequently. The fact that OER has been firm despite the collapse in this measure implies that strength in other segments of the rental market is more than offsetting this weakness.

It's hard to buy a home
Third, buying a home in the U.S. is still much less affordable, despite the recent fall in 30-year fixed mortgage rates from a peak of roughly 8% last October to just above 7% today. This should keep rents high and rising as more people who can't afford to buy opt to rent instead. Since 2019, the average monthly payment on a 30-year fixed mortgage (assuming a 20% down payment and using the national average home sales price) has jumped almost 70% (from $1,300 to almost $2,300 per month, according to our calculations). Over the same period, market rents for single family properties have increased 40%, according to Zillow, and OER has increased a little over 20%.

Takeaways
What does all of this mean? By our estimation, OER inflation is likely to continue to slowly moderate as pandemic-related effects fade. However, it seems premature to expect a quick return to pre-pandemic rental market trends. Over the next few years, OER inflation is likely to remain supported by higher market rents for single family homes, a catch-up in the average rents paid, and reduced home affordability compared with pre-pandemic levels. It could be well into 2025 before OER more fully adjusts to the post-pandemic reality in rental markets.

Given the recent BLS sampling shifts toward the previously underrepresented single family market, we also suspect the January volatility in OER could continue in future reports. Single family detached structures are harder to find and sample because individual units come to market so infrequently that it's not obvious to a government surveyor it's a rental property. As a result, the BLS will likely continue to increase the importance of the rental signals from the single family units it does manage to sample. This means that fewer numbers of units may drive reported average rent changes in the CPI – a recipe for more volatility.

All of this bolsters the argument that the Fed likely has a "last mile" problem. As we've emphasized in recent publications, the relatively painless disinflation of 2023 is likely to become a slower, more nuanced process in 2024. This doesn't rule out Fed rate cuts, but it means that absent a more material weakening in the economy and labor market, Fed officials may need more data before gaining enough confidence in the outlook for inflation to initiate rate cuts. Subsequent cuts also may progress more slowly than they have during historical average nonrecessionary easing cycles (for details, see Macro Signposts, "Central Bank Cuts: Lessons From History," 19 December 2023).

Read the previous edition of Macro Signposts on higher shipping costs and the potential impact on inflation and monetary policy.

We welcome your questions about the global macro landscape. Don't hesitate to suggest themes or data for us to analyze and discuss: Please email [email protected].

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¹ Brian Adams and Randal Verbrugge, "Location, Location, Structure Type: Rent Divergence within Neighborhoods," U.S. Bureau of Labor Statistics working paper 533, December 2020
² U.S. Bureau of Labor Statistics notice on the Consumer Price Index, "Recent and upcoming methodology changes: 2022," September 2022

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