The Inflation Battle May be Down to Housing and Shelter.

For almost two years, prices in the U.S. have been rising faster than normal. As a result, interest rates have gone much higher, much faster than normal. As fall 2023 unfolds, the level of inflation has cooled, with one exception: shelter inflation.

30 Year Fixed Rate

When the Bureau of Labor Statistics released its report on inflation in July, the headline consumer price index (CPI) moved higher for the first time in almost a year. Almost all media took the time to note that CPI, while 3.2 percent higher than July 2022, was less than 0.2 percent higher than in June. That pace, when annualized, comes in slightly less than 2.3 percent. Considering that annualized inflation in July 2022 was running at 9.1 percent, there has been great progress in beating back higher prices over the past year. Yet, neither the Federal Reserve Bank nor the markets seemed ready to declare victory in the battle to whip inflation.

It may be that those institutions have sufficiently long memories, and the echoes of the inflation battles of the late 1970s are still heard. It may also be that those institutions recognize what few in the media did on August 16, when the July report was released, that the current inflation battle was primarily about the higher costs of shelter, which can be very difficult to get under control.

In July 2023, shelter inflation accounted for 90 percent of the overall inflation rate. In the two months’ data available since that report, the share of inflation attributable to shelter costs has fallen. That decline has been due to a small surge in the price of oil and its related impact on gasoline and transportation, not because shelter prices have fallen. But, while shelter inflation is still higher than other components of the CPI and core CPI (which is CPI with food and energy prices stripped out), it has peaked. That’s good news for the inflation battle and the economy.

What’s not such good news is that shelter costs – be that rent or the cost of home ownership – have peaked at a level that is higher compared to its pre-pandemic levels than almost all other components that are used to measure inflation, up 12.4 percent. That is because shelter costs have been driven higher by both inflation in materials and labor and by an unusual shortage in the supply of houses or apartments. Therefore, there are two ways of looking at shelter inflation, a technical one and a practical one.

It is important to understand how shelter costs are calculated as part of CPI, not as an academic exercise but because the battle to tame inflation is central to the U.S. economy. The sooner that inflation returns to its historic norms, the sooner the Fed eases monetary policy. If the U.S. is to avoid a recession, the quicker the return to normal the better.

For the purposes of the government’s research on inflation, which is conducted by the Bureau of Labor Statistics (BLS), housing is considered a service that is consumed rather than an investment. The CPI is focused on consumption, both goods and services. For its calculation of CPI, the BLS measures market rents. For homeowners, that is translated to “implied rents,” the equivalent rent a homeowner would pay for a similar-sized rental dwelling.

“What the Bureau of Labor Statistics does is draw randomly from neighborhoods in a city and track rents in those neighborhoods,” explains Randal Verbrugge, senior research economist for the Federal Reserve Bank of Cleveland. “They also track home ownership shelter costs, but the way that works is if rents go up three percent, then shelter costs go up three percent. The data that goes into the CPI and the personal consumption expenditures index is all rents. Homeownership does not get into that data anywhere.”


This method is imprecise and ignores the actual mortgage, interest, and taxes paid by homeowners. Because of this, the government’s version of shelter inflation is criticized for overlooking the impact of higher interest rates on homeownership cost and extraordinary circumstances like the current housing inventory shortage. It also risks overstating the level of inflation attributable to shelter.

“Over time, both rents and home ownership costs go up at the same rate but there’s a pretty good lag. If home prices go up 10 percent, it’ll be at least a year before that is reflected in rents” says Verbrugge. “If house prices go way up people don’t buy houses. Instead, they rent. With more rental demand, rents go higher. What happens to the purchase market affects inflation down the road but, in the short run, those things can move in different directions. We expect that rents will decelerate over the next six months.”

“Home prices and rents in the long run need to track each other but there’s no reason in the short run why that must happen,” agrees Lara Loewenstein, research economist for the Federal Reserve Bank of Cleveland. “The way I think about it is that rent is the spot price. There is a market that needs to clear, and there is a certain demand for housing today. There is a certain supply of housing today and the rent is effectively what you pay for the housing that you are buying today. That price reflects not just that spot price but the expectations for that spot price in the future.”

All that is a bit technical for day-to-day living; however, the measure of how fast the cost of shelter is rising is currently a pivotal piece of information. Interest rates, including home mortgages, will remain elevated until lenders perceive that inflation has fallen to its historic levels. That impacts the costs of most things, and the affordability of housing directly.

A new method of measuring shelter inflation has been suggested by Leila Bengali, a regional policy economist in the Economic Research Department of the Federal Reserve Bank of San Francisco. Bengali proposes calculating the average monthly payment in each U.S. county or metropolitan area using a large random sample of mortgage data from residential mortgage servicers. This method would expand coverage beyond the limited geographic sampling done for the CPI and reflect actual payments associated with home ownership.

When consumer inflation peaked in summer 2022, the difference between the two methods was apparent. At the U.S. level, shelter inflation estimated for the CPI was at 5.8 percent, while the measure that used shelter payments was at 4.3 percent year-over-year. In certain fast-growing cities – like Phoenix and Atlanta, for example – CPI shelter inflation was roughly twice as accelerated as the payments method.

It will matter that shelter inflation cools over the coming year, and that the measurement of the rate of inflation reflects that. One fly in the ointment is that the home purchase market is experiencing an unusual imbalance in supply and demand that is unrelated to the main causes of inflation. Prices have risen because the pandemic disrupted the global supply chain while U.S. consumers received thousands in pandemic aid. Those extraordinary factors have receded in influence; however, the extremely short supply of homes for sale and under construction is the result of factors that are unrelated to the pandemic and have not receded.

Consumer Price Index

The long-term constraint on existing home inventory has been the change in behavior of older homeowners. While future generations have downsized or become renters in retirement, the Baby Boomer generation has remained in its family home for at least a decade longer than its predecessors. More Boomers from colder climate regions are able to maintain a second home in a warmer region, which is another drag on homes for sale. Finally, the spike in interest rates is a drag on homeowners who wish to sell their homes but would be trading a three percent mortgage rate for a seven percent rate. It is a perfect storm that is frustrating millions of buyers across the U.S.

Such an existing home shortage would be fuel for a new construction boom, but the new construction market is facing its own set of extraordinary hurdles to overcome.

Since the pandemic, runaway construction material inflation has been the principal problem for homebuilders, but hardly the only one. In most of the U.S., and in metro Pittsburgh in particular, there is a shortage of lots available for construction. There is also a severe shortage of skilled workers because the demographics of the construction workforce is skewed heavily towards older workers. And, since mid-2022, interest rates have made construction loans and mortgages more expensive. In Pittsburgh, construction of single-family homes is up year-over-year, but only by a few percentage points. That is far short of the increase in demand.

Builders are hopeful that the worst of the market conditions have passed, but they remain limited in how they can influence things like inflation, limited development, scarce land, and fewer workers.

“In the 25 years of my building career I have never seen as high inflation as we have the past two years,” says Jeff Costa, CEO of Costa Custom Homebuilders. “Since the middle of this year it has eased up. Inflation hasn’t stopped but I’m starting to believe that it will be in the three or four percent level again.”

“We are probably down to one third or 40 percent of the levels where commodity framing lumber and OSB panels were at the high point of COVID. That’s a significant drop. It’s not significantly out of line with where pricing has been for the past five or six years,” says David Jones, president of Brookside Lumber Company. “Now all the manufactured products – windows, doors, cabinetry, flooring, roofing, and siding – have gone up 15 percent to 40 percent and pretty much stayed up. Those products have reached a new level of equilibrium and we have not seen them pulling back. The other contributing factor is that labor is up significantly. That’s not only my labor, which has increased 30 to 40 percent, but also on the job site. Those are also contributing factors that are not going to go away.”

Costa observes that the market for the $500,000 to $750,000 home, which was formerly the sweet spot for Costa Custom Homebuilders, has become smaller. To his surprise, his backlog of homes under construction has shifted to homes over $1 million. He notes that buyers in that price range often have the resources to work around higher mortgage rates, often paying cash. They have seemed more resilient to the realities of construction inflation, which was more than 20 percent in 2021 and 2022. Costa notes that there was not much he could do to help customers when prices were spiking.

“We lock in our price with our customer. That’s a security measure for them but it’s not secure for us,” Costa says. “We took a haircut on a lot of homes. We would take bids on a home and prices would go up dramatically. Over a 25-year period, sometimes you bid when prices are stable, and you do well. If they go up a little bit, it’s usually fine but rising costs cut into your margins.  We can’t offer promotions like the national builders can. The best we can do is offer advice on better mortgage products that are being offered in the market.”

Paul Scarmazzi, CEO of Scarmazzi Homes, builds primarily for the empty-nester market, and he estimates that more than 70 percent of his buyers do not have a mortgage. But the cumulative effect of high inflation takes its toll on his prices too. That precipitated a shift in what Scarmazzi Homes is offering, which had been exclusively single-family detached homes in recent years.

“What we can do about shelter inflation is very limited. We have mostly cash buyers, but we talked about having a pool of money so that we can buy down a rate. Buying down a rate would mean $25,000 for one of our houses. We decided we didn’t want to do that,” Scarmazzi says. “In absolute dollars, the only thing we can do is pivot towards townhouses built efficiently, which is what we are doing. Our single-family houses cost a lot of money. We can save $20 per square foot off the price if we build efficiently.”

Scarmazzi explains that building costs are about the only area that a builder can influence the overall price of a home.

“The problem with land is that you can’t get the land cost down. Regulations continue to ramp up. Stormwater detention continues to be more complicated and costly. Dirt isn’t getting any cheaper. Ductile iron pipe isn’t getting any cheaper. Fuel isn’t getting any cheaper,” he says. “We are already doing 60-foot lots at $100,000-plus from a market value standpoint. I scratched my head trying to figure out how to help with affordability. I’m just not that smart.”

Lenders feel similarly constrained by market conditions. The giant leap ahead in interest rates has meant a big increase in revenue for banks; however, it has also meant a giant leap in costs, as banks have to offer higher savings rates to attract or retain depositors. And interest rates are a global, not local, condition. Each bank gets to set its own mortgage rates, of course, but lenders cannot wander too far from what the market is charging or offering without losing money or market share. The only way a lender can offer a much better deal than one of its competitors is by making less money.

“There is not much we can do to change rates,” says Mike Henry, senior vice president of residential lending for Dollar Bank. “We have plenty of down payment assistance programs. We’re involved in the OwnPGH program, where people can get up to $90,000 as a grant and $40,000 as a soft second mortgage. If you are looking at a $150,000 house now you can borrow $60,000 and get into the house. We are always trying to find some creative programs, but higher rates make it tough, especially if someone wants to build a house. Prices for new construction keep going up and interest rates are keeping people out of the mix for sure.”

Henry acknowledges that higher mortgage rates have edged some buyers, who were qualified for a mortgage in 2022, out of the market in 2024. However, for the majority of buyers, he does not believe that rates are the primary reason fewer homes have changed hands.

“I’m finding the people who want to buy a house are not being restricted by interest rates. It’s inventory,” Henry says, noting that mortgages signed at today’s rates can be easily refinanced when rates go back down. Costa says he also reminds rate-wary buyers about refinancing.

“I tell buyers to marry the house and date the rate,” jokes Costa.

The practical solution to the elevated shelter inflation rate is for supply to get ahead of demand. While that is not likely to occur in the foreseeable future, history suggests that both buyers and sellers will adjust to the new rate environment if it continues through 2024. By mid-2024, sellers who wanted to move up or relocate will have remained in place for two years because of the fear of trading for a higher mortgage rate. Likewise, potential buyers – especially those who are renting – will begin to lose patience waiting for rates to come down. The motive that people had for selling or buying in 2022 will mostly still be true in 2024. At some point those motives will be compelling, regardless of rate.

For new construction, the tipping point may well be a willingness to buy or build in communities that are not the most desirable. That means school districts that are not on the top of most buyers’ lists. Around metropolitan Pittsburgh, there are numerous areas within 30 minutes of Downtown that see little new construction, even though there is land. With developable land growing scarcer, will the production-oriented builders – including newcomer D. R. Horton Inc. – begin to look at areas that are second choices for homeowners to meet their goals for construction? And will buyers, who have few choices for new construction under $500,000, accept those second choices?

If they do, it is likely that the market will reward them. The long-term demographic trends and topographic challenges in Western PA will keep home values from falling, even in tough economic times. Especially for those who build or buy in the next couple of years. The Pittsburgh housing market still has a long way to go before supply catches up with demand.

“We’re still seeing multiple offers on homes and sales above list price; and the homes are appraising,” says Henry. “That has not been a problem.”  NH