On the Perceived Affordability of Buying, Rents, and the CPI

I thought this was an interesting and concise summary of the situation at hand:

As real estate prices spiraled upwards over the last ten years, artificially low interest rates and lax lending standards were not the only factors helping to maintain housing affordability. Just as important were the expectations of future price appreciation and the suppression of the rental market. With these two factors largely reversed, the housing market is much more vulnerable than most people understand.

Given that many people expected to extract money from future appreciation, which could help pay mortgages, taxes, maintenance, and insurance, houses actually seemed cheaper to buy, despite soaring sticker prices. On the other side of the coin, without offering the bounty of free cash, the rental market suffered a multi-year torpor. Flat rents anchored a rock-bottom core CPI, which allowed the Fed to keep rates low and the cheap mortgages flowing.

As the slowing housing market increases the perceived cost of buying, renting becomes a far more compelling option.

Rents make up 40% of the core CPI, and are by far the index' largest component. For the reasons outlined above, a softening housing market eliminates the financial advantages of buying and increases demand for rental properties. Recent data shows that national rents are increasing at a rate not seen in more than five years. This has begun to show up in the core CPI, which will continue to grow with the surging rental market. Just as rising home prices paradoxically suppressed the core CPI, falling real estate prices will now do the reverse. A more rapidly rising core CPI will force the Fed to continue raising rates, putting even more pressure on home prices, and initiating a particularly nasty spiral.

The Fed of course now has a real conundrum on its hands. It either plays down the significance of the core, possibly excluding rents entirely as they now do food and energy, or continue to raise rates even as housing prices collapse. The former, which amounts to a version of "heads I win, tails you loose", risks exposing the Fed as hypocrites. The loss of any remaining faith in the Fed will cause a run on the dollar and even more inflation. On the other hand, to continue raising rates will surely tip the economy into a recession.

My guess is that the Fed is already preparing the markets for a pause even as core consumer prices continue to rise. The spin will be that peaks in core consumer prices historically occur with a lag relative to the end of a tightening cycle. This will likely buy the Fed a little extra time until the markets finally notice that rather than peaking, core prices just keep on rising. Therefore, the greatly anticipated, highly illusive pause will not be the least bit refreshing.