May 27, 2022
There is good reason for believing that the prices of many items that drove inflation higher in the last year have stopped rising and are may even be going in the opposite direction. Used cars are the best example. The CPI index for used vehicles rose 40.5 percent from January 2021 to January 2022. In the three months from January to April, the CPI index has fallen by 4.5 percent.
More generally, the supply shortages that drove prices higher in 2021 seem to be replaced by gluts, with major retailers like Amazon and Target complaining about stockpiles of unsold goods. With the stimulus measures from the pandemic fading into the past, and people no longer fearing to travel or go to restaurants, it is likely that we will be seeing serious downward pressure on the prices of many goods.
While inflation may be easing on the goods side, there are questions about prices in the service sector, most importantly rent. Rent accounts for more than 31.0 percent of the overall CPI, and almost 40 percent of the core index.
Rental inflation had been running at close to a 3.5 percent annual rate before the pandemic. It slowed in 2021, but is now running at almost a 5.0 percent annual rate. There are reasons for believing that it could go still higher. Home sales price growth has been in the double digits the last two years. Many indexes of market rents (units that change hands) have also shown double-digit growth. This raises the possibility that the CPI measure of rental inflation (which covers all units, not just those that change hands) will increase even more rapidly in the rest of 2022 and 2023.
Given its importance in the indexes, and people’s spending, it will be hard to contain inflation if rents are rising at a 5.0 percent, or higher, annual rate. Fortunately, there are some reasons for believing that we may be seeing downward pressure on rental inflation also.
First, the Fed’s interest rate hikes have had a huge impact on home sales. The interest rate for 30-year mortgages has risen by more than 2.0 percentage points, causing home sales to plummet. In recent weeks, purchase mortgage applications have been down by double-digit amounts from year ago levels. Other data, like pending home sales, also show a sharp drop off.
While the relationship between the ownership market and rental market is somewhat indirect, fewer homes being sold is likely to somewhat increase the supply available to renters. To see this point, consider three possibilities.
In the first, would be homebuyers deterred by higher interest rates were looking to move from either a rental or ownership unit of roughly the same size. In this case, the fact that they don’t buy a home has no impact on the overall demand for housing. They just would have occupied a different unit, leaving their current home vacant.
In a second case, imagine that the would be homebuyers were planning to occupy more space. Perhaps they would have moved from a one-bedroom apartment to a three-bedroom house. Alternatively, maybe they were sharing an apartment or house and would have instead have their own, if they bought. In this case, their decision not to buy frees up space that they otherwise would have occupied. That means, other things equal, downward pressure on rents.
It is important in this story to recognize both, that houses can be, and often are divided so that they are shared by multiple individuals or families. This can happen either because the owner formally divides a house explicitly into multiple units, or multiple individuals choose to share a house. Also, houses can be rented if they are not sold. Roughly 30 percent of rental units are single family homes.
The third case is where a would be homebuyer is looking to buy a second home. If higher interest rates make this impractical, then another unit is freed up for somewhat else to occupy.
While a large share, perhaps the majority, of would be homebuyers fall into the first category, people buying homes with comparable space to their current apartment or house, clearly a large number fall into the second and third categories. Therefore, it is reasonable to expect that higher mortgage rates will also help to lower rents.
It is worth mentioning that higher rates are likely to discourage construction and thereby have a negative effect on supply. This is true, but with the sharp run-up in prices over the last two years, homebuilders would have far more incentive to build even with higher interest rates, than they did at the start of the pandemic.
There is also reason to think that the supply of housing will be increasing simply due to the easing of supply chain problems. During the pandemic, it became difficult for builders to get many items needed to finish a home. As a result, while housing starts rose to an annual pace of almost 1.8 million, completions rose little from their pre-pandemic pace of 1.3 million. With supply problems gradually being addressed, we should expect completions to rise to near the rate of housing starts. This will mean a substantial increase in the supply of housing over the next six months or year.
Finally, I should also add a somewhat morbid, but important point, to the rental picture. In an ordinary year there are close to 1 million evictions. We had around half this number in 2020 and 2021, due to eviction moratoriums. Thankfully, we have not seen the flood of evictions many predicted when these moratoriums ended, but we should expect to see evictions get back to their normal pace. This will also free up some units, putting downward pressure on rents.
Converting Office Space to Residential
As the pandemic has dragged on longer than most of us expected, the remote work arrangements that many companies adopted look to become permanent. Dates for returning to the office were continually pushed off, and now many companies are planning to live with a situation where a substantial share of their workers are expected to show up at the office either infrequently, or not at all.
As a result, many office buildings are now largely empty. The number of workers going into offices nationwide is still less than 40 percent of its pre-pandemic level. This huge amount of vacant office space offers the quickest route for increasing the supply of housing.
While it is true that many new office buildings cannot be easily converted to residential units, that is really beside the point. What we would expect is that as a glut of office space pushes down rents. Landlords in buildings that can be more easily converted will turn their space into apartments or condominiums. This would push tenants that had been using these buildings for offices into the buildings that are not easily converted to residential usage.
This is a straightforward market process, but it can be helped along by government. Unnecessary zoning barriers that make such conversions difficult can be relaxed. Governments can also inventory best practices, sharing examples of buildings that have been successfully converted. Low interest loans, to subsidize conversions, as well as the moves of tenants who need new space, can also be helpful.
There are undoubtedly many other policies that can hasten this process without large expenditures or bureaucracies, but governments have to agree that this is the route they want to follow. As it is, many politicians, most notably New York Governor Kathy Hochul and New York City Mayor Eric Adams, have been leaning on companies to bring their workers back to the office.
Hochul and Adams are responding to the thousands of businesses that are dependent on the throngs of commuters that used to come into Manhattan every day. With this figure slashed by more than 60 percent, many of these businesses cannot survive.
Their concern over these businesses is understandable, but we are seeing a permanent change in the economy, and New York and other cities will simply have to adapt. Most of the millions of workers newly given the opportunity to work remotely value this freedom. They can save thousands of dollars a year on commuting and other work-related expenses. In addition, they save the time needed for commuting, which can easily be ten hours a week in a major city like New York.
For these reasons, it is understandable that many workers do not want to return to the office. Employers that do not allow their employees to work remotely are likely to find themselves at a serious disadvantage in their efforts to attract and retain workers. In short, remote work is now a fact of life, we cannot turn back the clock.[1]
While this is bad news for the businesses that depended on a commuting workforce, it does not have to be bad news for cities. If the office space is converted to residential space, it will increase the number of people living in cities. The new residents will also require services from businesses, even though these may be different than the needs of the commuting population.
Also, additional residential space will put downward pressure on rents more generally. This is bad news for landlords, but it will mean more money for renters, who will now have more money to spend on things other than rent.
Even without large-scale conversion of office space, we have seen a sharp slowing of rental inflation in some of the highest cost cities. The CPI measure of rent has increased by close to 1.0 percent over the last year in New York, San Francisco, and Washington, DC. This likely reflects many people taking advantage of increased opportunities for remote work to move to lower cost parts of the country.
The flip side of this story is that rents in lower cost cities, like Detroit, Atlanta, and Phoenix, have far out-paced the national rate of rental inflation over the last year. This is fine for the renters who are moving from much higher cost cities. The resulting rise in house sale prices is also good news for homeowners in these places. However, it is bad news for those who were already renting in these lower cost cities, although the impact might be largely offset by increased job opportunities resulting from an influx of relatively affluent workers. In any case, this migration is almost certainly a net positive, even if there are likely to be some losers.
The Prospect of Lower Inflation Going Forward
Most of the new data that we have seen in the last few months supports the view that inflation is coming down, rather than spiraling upward. The Congressional Budget Office threw its lot in with this view in its latest budget and economic outlook. In many areas, the price declines will come about through the normal working of the market, however in the case of rent, the government can help to counter inflation by encouraging the conversion of vacant office space to residential units.
[1] Remote work is also great for the environment, since it means less carbon emissions from commuting.
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