It's generally accepted among economists and investors that the Federal Reserve has an impossible task of getting inflation under control without broad and lasting damage to the economy. It's time for a reality check. In fact, it's looking more and more like the central bank may have a far easier time curbing inflation than is widely expected.
The reason why is that deep structural shifts in the economy caused by the pandemic, changes in the composition of the housing stock and an evolution in cultural norms have made household formation much more flexible than anytime in the past. Perhaps more than anything, it's that last point that will be the difference between an economy that requires a sharp rise in unemployment to bring down inflation and one that simply needs a brief but firm tap on the brakes.
When the Fed began boosting rates earlier this year, there was justifiable concern that the effort would backfire. After all, many of the drivers of inflation were outside the central bank's direct control.
Take residential real estate, for example. The Fed doesn't have any direct control over rents, and what indirect control it does have tends to push rents in the wrong direction. A straightforward consequence of the Fed's tightening of monetary policy and the resultant jump in mortgage financing costs was that demand for homes fell. The natural corollary to falling home demand should be upward pressure on rents. After all, if fewer Americans could afford to buy, doesn't that mechanically lead to more renters? That's a problem because the largest component by far in core inflation is shelter costs, or the user cost of housing.
The quandary, then, was how would the Fed bring down core inflation when the largest component is determined by rents and the central bank's primary tool – raising interest rates – was working to drive rents upward? The traditional answer has been to drive up unemployment. As unemployment rose, more young adults would be forced to move back in with their parents or double up. That's exactly what echoed through the economy in the wake of the Great Recession, when new home construction collapsed to record lows and only very slowly recovered. Despite the plunge in supply, rent inflation – as well as overall inflation – was subdued because of a large slowdown in household formation.
Which brings us back to why the Fed's job may get easier from here.
Anecdotal evidence suggests that household formation is rapidly slowing. A UBS AG survey found that the percentage of adults living rent free with friends or family jumped from 11 percent a year ago to 18 percent this September, the highest on record. And according to rental data tracking firm RealPage, demand for apartments fell from more than 200,000 units in third quarter of 2021 to a negative 82,000 the same time this year. That marks the first-ever negative reading for the third quarter – typically the strongest leasing season – in more than 30 years.
Several forces seem to be at work. First, the pandemic caused an explosion in household formation. Between the spring of 2019 and the spring of 2020, some 4 million new households formed, about four times the average annual rate, as shared living arrangement became cramped as working from home soared during the lockdowns. Then, the ability to work remotely and the extra cash provided by fiscal stimulus programs gave more people the opportunity and the means to seek larger homes farther away from urban centers. That extra space provides more people with the capability to host a friend – albeit somewhat uncomfortably – when times were tough.
In addition, the median size of new homes has grown by more than 10 percent since the Great Recession to 2,312 square feet. By comparison, the median existing home size in the U.S. is just 1,650 square feet. This implies that an increasing number of Americans, particularly those who are older and more well established, have the ability to house family and friends.
Here, again, COVID seems to have accelerated these trends. During the height of the pandemic, more than half of all young people ages 18-29 lived with one or both of their parents, according to Pew. In many cases, these were college students returning home as campuses shut down, which explains how both household formation and young adults living with their parents could increase at the same time. Crucially, however, even before COVID the norms were changing. In February 2020, 47 percent of young adults lived with a parent, the most since 1930. In 1960, only 29 percent of young adults lived with a parent.
These shifts in work flexibility, home size and cultural norms are working together to make household formation more sensitive to economic conditions than in the past. On top of that, there are a record number of housing units under construction, rising to 1.71 million from less than 1.2 million before the pandemic.
Rising interest rates are likely to slow construction, but with apartment demand already showing signs of rapidly cooling, the net effect is that new homes are likely to run well ahead of household formation for the next year or two. That will bring down rents and overall core inflation. It will take some time for this to all show up in the consumer price index data, given the way the government calculates the data, but given the current softening trajectory of real-time measures like the Zillow Rent Index, expect CPI shelter inflation to peak soon, maybe as soon as early next year.
How shelter inflation falls will depend on how firmly the Fed is able to restrain the economy. If it decides to raise its key rate to around 4.5 to 4.75 percent and then pause, my guess is that it would be enough to get shelter inflation back down to the 2 to 3 percent range by early 2024. That's hardly a backfire.
About the writer: Karl W. Smith is a Bloomberg Opinion columnist. Previously, he was vice president for federal policy at the Tax Foundation and assistant professor of economics at the University of North Carolina. Distributed by Tribune Content Agency LLC.