Super-charged inflation has the Fed re-thinking their interest rate strategy

California real estate professionals are intimately familiar with the dynamics of low supply and high demand, which have caused infamously high home prices and rents across the state. Now, as low supply meets high demand in other sectors of the economy, rapidly rising prices are spreading, causing unstable levels of inflation.

The Consumer Price Index (CPI) measures consumer inflation through fluctuations in the price of goods and services. After floundering at the outset of the 2020 recession and pandemic, this index has jumped over the past year, at 5.4% above a year earlier as of September 2021, according to the Bureau of Labor Statistics (BLS). For reference, the Federal Reserve (Fed) target for inflation is just 2%.

When inflation rises too fast — beyond the pace of wages — consumers end up paying a larger share of their paycheck on everyday items and needs. For example, whereas before they might have paid 10% of their income on food, now they are paying 11%. This may not seem significant, but when inflation is occurring in every aspect of your life, it adds up quickly.

The result is less money left-over for saving — say, for a down payment — and participating in the economy.

The rent-inflation connection

While many economists believe today’s rapid consumer price inflation is only temporary as the supply chain adjusts to pandemic factors — what the Fed calls transitory inflation — rising rents present a contradiction. Namely, most rents are set for a period of 12 months. Thus, when a tenant’s rent rises 10% in 2021, it will remain at that level throughout 2022.

Even after the supply chain returns to “normal,” rents will likely increase further due to the backlog of residential construction. That’s because, on top of social distancing obstacles, supply chain disruptions have caused material costs to rise, delaying construction at a time when it is needed most. From planning to completion, new construction takes several months or even years to occur. Thus, today’s supply chain disruptions prolong California’s housing shortage for years to come.

So, what’s the Fed to do?

To control inflation in 2021, the Fed seeks to maintain a delicate balance of keeping prices in check, while also encouraging hiring. In California, there are still just over 1 million employed workers missing from the labor market as of September 2021 compared to the pre-recession peak. At the same time, rents continue to rise, with average residential rents:

• 20% above a year earlier in Riverside;
• 15% above a year earlier in San Diego;
• 14% above a year earlier in Sacramento;
• 11% above a year earlier in Los Angeles;
• 6% above a year earlier in San Francisco; and
• 5% above a year earlier in San Jose, according to Zillow.

To meet these higher rents, tenants are demanding higher wages, which further fuels the inflationary cycle. To break the cycle, the Fed can raise its benchmark interest rate, which will curb price increases and give everyone some much-needed inflationary relief. But to raise interest rates prematurely is to cut short employment growth, as explained in the New York Times.

Thus, the Fed is left to choose between allowing inflation to run amok, or choking the jobs recovery. The most recent Fed remarks indicate they will continue to preference job growth, leaving inflation in the hands of the private sector, for now.

Expect inflation to stick around into 2022 while the supply chain continues to adjust and demand subsides. Rents will likewise continue to rise alongside the ongoing housing shortage, increasing the burden on tenants and stunting future homeownership prospects.

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