Lower Housing Costs Will Not Bring Inflation Down

Inflation optimists are betting that lower housing costs will bring down inflation. They seem to have some arithmetic on their side, but their theory of why inflation rises or falls is fallacious. Declining home prices and rents will not dent our inflation problem.

One explanation of the housing-inflation connection is described by the excellent economist Alan Reynolds. He notes that the Consumer Price Index excluding shelter has been flat the last six months. He also notes that the shelter component of the CPI typically lags observable price changes, such as declines in home prices reported by the Federal Housing Finance Administration and changes in rents reported by Zillow and ApartmentList. (The calculation of housing costs in the CPI is not intuitive. The Brookings Institution has a good explanation.)

The fallacy is thinking that inflation is the sum of all the price changes in the economy. As if when one important item starts dropping, then inflation is reduced. The more accurate view is that inflation is the result of stimulus to the economy in excess of our productive capacity. Individual price changes are simply the manifestation of excessive aggregate stimulus. If one price stops rising, the excess demand will show up elsewhere.

Remember the jump in used car prices back in the summer of 2020? Back then Reuters reported, “A 5.4% jump in prices of used cars and trucks, the largest gain since March 1969, accounted for more than 40% of the rise in the so-called core CPI last month.” This led some analysts to think that used cars were causing the inflation increase. In reality, people received stimulus payments early in the pandemic. They could not travel or dine out. Many of them decided to upgrade their rides. But the supply of used cars is pretty much fixed; it takes about three years to make a three-year-old car. So the stimulus-fed demand pushed up the prices of used cars. Later, people gave up on finding a good used car at a reasonable price and they spent their money elsewhere. That’s when inflation spread more widely.

Government checks were only part of the story. The Federal Reserve’s interest rate cuts and purchases of financial assets were another part of the overall stimulus. People bought—or tried to buy—single family homes. And even more people refinanced their mortgages at much lower rates, giving them more money to spend. That pushed up home prices.

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People who were not thinking about buying houses also had more money, both from those stimulus checks and from pay raises. Many decided to live alone. They either moved out of their parent’s basement, kicked out a roommate or divorced a spouse. Apartment rents rose in response to increased demand. And thus stimulus drove up the shelter component of the CPI.

Home prices and apartment rents have started declining in recent months. Many people have decided that at current prices and mortgage rates, buying a house does not make sense. Others have looked at their finances and decided that between high rents and high prices for everything else, a roommate isn’t so bad after all.

What will bring down inflation is not the housing sector specifically, but the overall reduction in stimulus. The fiscal policy side of stimulus is flattening, but at a pretty high level. Monetary policy is tightening. These actions will bring inflation down. But the changes in particular prices are simply where we will see the results. Drops in shelter or used car prices will not be the cause of lower inflation, but simply where the lower inflation will show up.

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