Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / Why Housing Inflation Isnt Going Away
Transcript
- Lucas: So core PCE came in at 3.3 percent for April, exactly as expected, and the market basically shrugged. But if you look under the hood, there's one line item that is keeping this number stubbornly high — and it's the same one that's been frustrating the Fed for over a year now. Luna: Let me guess — shelter. Owners' equivalent rent specifically. Lucas: Yeah. Shelter costs account for about a third of the CPI basket, and they're running at an annualized rate of 4.8 percent. The Fed expected this to cool off by now based on the lagging indicators they track, like new lease data. But it hasn't. Luna: And that lag is longer than anyone predicted. I've seen estimates that OER lags market rents by twelve to eighteen months. So the rent declines we saw in 2024 should be showing up now, but they're not. Lucas: Right — and there's a structural reason why. If you think about how OER is calculated, it's not based on what new tenants are paying. It's based on what homeowners think their own home would rent for. That survey-based number is sticky because homeowners anchor to their own mortgage costs, which have gone up. Lucas: So even if market rents in, say, Austin or Phoenix are falling, the national OER number barely budges. And that's what's keeping core inflation above three percent. Luna: Which brings us back to the rate cut question. The Fed wants to cut, but they can't ignore this. And the market is pricing in a cut in September, but if shelter stays this sticky, they might have to wait longer. Lucas: Exactly. And — you know, this is a good moment to mention something. We talk about this every day on The Macro Memo, and we deliberately don't run ads on these shows. If walking through the economy with us has made something click, and you want to support that choice, the link is buy me a coffee dot com slash fexingo. Luna: Yeah, it's a small way to keep this independent. And we appreciate it. Lucas: So back to that shelter number. The Fed's own projections from the March meeting show core PCE ending 2026 at 2.8 percent. But if shelter doesn't come down, that forecast is going to be hard to hit. Luna: And there's another layer here — the bond market. The ten-year yield is at 4.45 percent, down a bit this week, but still well above where it was when the Fed started cutting. That's partly because the term premium is higher, and partly because investors are pricing in a higher neutral rate. Lucas: Right — the r-star debate. If the neutral rate is higher, then the current fed funds rate of 3.64 percent isn't as restrictive as it looks. And that means the Fed might not need to cut as aggressively. But that also means housing stays expensive. Luna: Because mortgage rates are anchored to the ten-year, not the fed funds rate. So even if the Fed cuts, mortgage rates might stay elevated if the term premium is high. Lucas: Exactly. And that feeds back into OER — homeowners see high mortgage rates, they think their home is more valuable to rent out, and the survey responses stay high. It's a bit of a loop. Lucas: Meanwhile, consumer sentiment is at a record low. We talked about that paradox before — people feel bad even though the economy is growing. Housing is a big part of that. If you don't own a home, you feel priced out. If you do own, your property taxes and insurance are up. Luna: And the Iran war is adding energy costs on top of that. CNBC reported the average household is paying 450 dollars more per year on gas and energy. That's a direct hit to disposable income. Lucas: So you have shelter inflation sticky at 4.8 percent, energy inflation popping again, and core services ex-shelter also running hot. That's why the Fed's preferred measure is stuck at 3.3 percent. Luna: And the labor market is still tight. Initial jobless claims ticked up to 215,000, but that's still low historically. Average hourly earnings are up to 37.40. So consumers have money, but they're spending it on higher costs. Lucas: Which brings us to the real question: what breaks this cycle? The Fed needs shelter inflation to moderate. Historically, it lags market rents by about a year. But the mechanism is broken right now because of the mortgage rate lock-in effect. Luna: Yeah, people with 3 percent mortgages aren't moving. That reduces supply of existing homes, which keeps home prices high, which keeps OER high. It's a feedback loop. Lucas: And the Fed can't fix that with rate cuts. In fact, cutting rates might make it worse if it brings more buyers into the market without increasing supply. That's the conundrum. Luna: So what are you watching for in the next few months? The May CPI report, or the Fed's dot plot in June? Lucas: Both. But I'm actually more focused on the shelter components of CPI and PCE. If we see OER finally start to decelerate in the May or June data, that's the signal that the lag is finally playing out. If not, then the Fed's 2026 forecast of 2.8 percent core PCE is at risk. Luna: And the market might have to reprice rate cuts. Right now the futures are pricing in about two cuts by year-end. If shelter stays sticky, that could drop to one. Lucas: Or zero. And that would be a shock to equities, especially the small caps that have been rallying. The Russell 2000 is at 2,919, up 1.7 percent in the last five days. That rally is built on rate cut expectations. Luna: So housing is really the key variable for the second half of the year. It's not just about shelter costs — it's about the entire macro narrative. Lucas: Exactly. And it's why we keep coming back to it. The housing market is the slow-moving engine that's driving inflation, consumer sentiment, and Fed policy all at once.