Why this UCI economist says the Fed misread rent inflation


Ed Coulson, director of the Center for Real Estate and economics professor at the Paul Merage School of Business at UC Irvine. (Photo by Paul Bersebach, Orange County Register/SCNG)

Rent hikes soared into the double-digits in mid-2021, but the Federal Reserve didn’t start raising interest rates until a year later.

Ed Coulson, director of the Center for Real Estate at UC Irvine, believes the Fed should have acted sooner. And because rent is now leveling off, he thinks the Fed should halt future interest rate hikes.

Rent inflation plays an outsized role in determining the overall rate of inflation, the housing economist said. And the government’s method for measuring it is off-kilter, causing the Fed to misinterpret an important metric in the Consumer Price Index.

We asked Coulson to explain his reasoning and to share other insights about the housing market. His comments have been edited for space.

Q: You believe the Bureau of Labor Statistics’ method of measuring rent inflation is flawed. Why is that, and why is it important?

A: The Fed’s policy is driven by their perceptions of inflation. And I argue with some co-authors that that perception is incorrect. And the reason it’s incorrect, ironically, has to do with the housing market.

The problem is rent is the biggest component of the Consumer Price Index. Depending on which measure of inflation you want to look at, it can be anywhere from just over 30% to 45% of the basket of goods, which is used to measure inflation. So it’s a big chunk. And so you got to get it right.

Q: What are they getting wrong?

A: They go around, they ask people what their rent is. And they look at what your rent is now compared to what it was six months ago. And then, they combine all those answers and figure out the rental inflation rate from that.

That’s great if you want to measure the cost of living. But you’re not using it to measure the cost of living, you’re using it to advise you on macro-economic policy. That’s not contemporaneous information because the rent you’re paying right now depends on a lease that you signed six, eight, 10 months ago.

So, it is very sluggish and lags the true state of the housing market by six months at least.

If (the Fed) had measured inflation properly, they probably would have raised rates very much sooner than they did. And they should stop raising rates now because rents now have leveled off. In fact, our measure of current rental inflation is zero when the Fed still is measuring it at 3% to 4%.

Ed Coulson, director of the Center for Real Estate and economics professor at the Paul Merage School of Business at UC Irvine. (Photo by Paul Bersebach, Orange County Register/SCNG)

Q: Are you saying rent inflation should be based on new leases for vacant units?

A: That’s what you want. We have a more recent technique, which simply takes Real Capital Analytics data on the multifamily market, and we can convert that into an apartment rent inflation index.

And if you input that into the CPI and take out the Fed’s rental measure, it shows a drop in the rental inflation rate.

Q: How has the pandemic affected housing?

A: From 2020 to 2022, we had 4 million new households form nationwide. That’s a lot. Four million in two years is a lot of new households.

Why did this happen? It’s because people were adjusting their housing preferences because of the pandemic. They didn’t want as many roommates as they did before. They didn’t want dense living. They wanted larger spaces because they needed separate space devoted to a home office.

That increased the demand for housing. And so prices and rents shot up. At the same time, the pandemic induced inflation.

In light of that inflation, interest rates rose, and they rose dramatically because the Federal Reserve thought it was their duty to put a cap on this inflation.

Q: Is there enough housing to meet all this new demand?

A: Normally, we always have churn in the housing market. Empty nesters want to move to smaller units; people who are increasing their family size want to increase their space.

But that’s not happening now.

The incentives are all misaligned because we are in this period of very high mortgage interest rates that follow a period of very low interest rates. And so people are experiencing what we call mortgage lock, meaning that they don’t want to trade that low interest loan for a high interest loan.

Q: Would building more homes increase supply?

A: I think we do need denser housing. … (But) building more housing isn’t necessarily going to reduce housing prices. The price of housing in California — and everywhere — is based on some fundamental factors. How prosperous the place is and how many amenities it has, and what kind of amenities.

And places with sunshine and coastline are always going to be more expensive. And when people talk about how high housing prices are in California, you have to remember that that’s not just the price of the housing. It’s the price of the sunshine as well.

If house prices were to drop considerably in Southern California, there would be people in other places who would say, “Hey, California is pretty cool.” There’s big demand out there for living in California.

Q: With home prices and mortgage rates so high and so few homes on the market, will homeownership decline?

A: You’ve got the worst of both worlds because you got high prices and high interest rates. People who are looking to buy a home are currently stuck.

Q: Does this mean in the long run, that people are more often going to become renters than owners?

A: Well, there’s still going to be wealth-building advantages to owning a home. And there’s the pride of ownership that comes with owning a home.

Traditionally, if you wanted to have a single-family property, you had to become a homeowner. Now, of course, the single-family rental market has been expanding, so the people who have families, who have dogs (are no longer) limited to becoming homeowners.

I do worry because I have written papers that suggest that homeownership is a net benefit for neighborhoods because they have more invested in the property than either a renter or what is, in effect, an absentee owner would.

And so, if there’s a transition to a lower homeownership society, we would need to worry about people’s shorter stays and less investment in their neighborhood. I’m not saying that renters are bad people. Not at all.

California’s always had a lower homeownership rate. And people in places that have high housing costs relative to rents are always going to have lower homeownership rates.

Are we are we heading there? Well, I don’t know.

ED COULSON PROFILE

Title: Professor of Economics and Director of the Center for Real Estate

Organization: Paul Merage School of Business, University of California, Irvine

City of residence: Dana Point

Education: Bachelor’s in economics from UC, Riverside; doctorate in economics from UC San Diego

Previous jobs: Professor of Economics and King Faculty Fellow in Real Estate at Pennsylvania State University; professor of Economics and director of the Lied Institute for Real Estate Studies at the University of Nevada, Las Vegas.



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