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The Fed and Housing

Eakinomics has been flagging the importance of shelter inflation for nearly a year. In January, year-over-year shelter inflation was 4.4 percent. In the September Consumer Price Index (CPI), it was 6.6 percent; in between there has been month after month of uninterrupted rise. It is even truer now than it was in January that it is awfully hard to hit an overall inflation target of 2 percent when one-third of the CPI is rising at such a high rate.

It also remains true that the Fed’s anti-inflation strategy is destined to have a disproportionate impact on the housing sector. Not only do interest-rate hikes increase the cost of residential and commercial mortgages, the process of shrinking the balance sheet (“quantitative tightening,” or QT) means pulling up to $35 billion of mortgage capital out of the market. That’s a big swing from injecting $30 billion monthly in 2020 and 2021 and is tantamount to even higher rates on mortgage finance.

In short, the Fed has to deal with shelter price inflation and its procedures will deal with shelter inflation.

That doesn’t mean everybody likes it. As detailed in Politico this past Friday: “The housing slump is the economy’s biggest casualty so far from a series of Federal Reserve rate hikes designed to tame inflation.”

“Groups representing builders, realtors and lenders are urging Congress and the White House to intervene to spur more home construction and boost affordability. It’s an increasingly urgent plea, with mortgage demand down more than 40 percent from a year ago and rates topping 7 percent for the first time in two decades.”

The phrase “spur more construction” is D.C. code for “raid the taxpayers’ wallets and spend it on housing.” To make a dent in the supply of owner-occupied homes and apartments would require a lot of money – certainly north of $200 billion – and quickly. These advocates (correctly) point out that if one could snap one’s fingers and create a substantial increase in the supply of houses and rental units, shelter inflation would come down. But such a program would be a fool’s errand.

When the Fed raises rates, mortgage rates rise, the demand for mortgages and homes falls, and the construction of houses and apartments decreases. But, importantly, the impacts do not stop there. When fewer units of all types are built, no furnaces are put in them, no refrigerators are installed, no carpeting is laid, no furniture is purchased, and generally demand is dented across the economy. That is one element of reducing inflation in the two-thirds of the CPI that is not shelter.

The housing advocates are essentially arguing to undo this or worse by boosting housing construction and stimulating demand across the economy. Even if shelter inflation went away magically, inflation elsewhere in the CPI has to fall to 3 percent to hit the inflation target. The Fed will not be able to tolerate this large, spillover demand stimulus. It will be forced to raise rates even higher to offset the housing program, and reduce both shelter and non-shelter inflation.

The proposed strategy by housing advocates will accomplish nothing but slowing and making more painful the Fed’s fight against inflation. Admittedly, none of this analysis is good news. But it is a reminder that once inflation is embedded in the economy, there are no good, easy choices. Either live with the inflation or accept the consequences of the steps needed to fight inflation.

Disclaimer

Fact of the Day

Across all rulemakings this past week, agencies published $1.1 billion in total costs and added 3.5 million annual paperwork burden hours.

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