Interest rate cuts are difficult! Powell's wishes may have to wait until 2026

Federal Reserve Chairman Jerome Powell stated last week that officials are closely monitoring the "not fully normalized" inflation in the real estate sector. They may need to wait more than a year.

According to research from the Cleveland Fed, the rental inflation rate in the Consumer Price Index (CPI) may not return to pre-pandemic levels until mid-2026. Researchers noted that while several indicators suggest new rents are declining, fewer people are moving and signing new leases, meaning the sample in the CPI does not reflect greater mobility.

Housing inflation is the largest category in the CPI, accounting for more than half of the monthly increase in October. If the index remains elevated over the next year and a half as the Cleveland Fed predicts, this will pose a challenge for policymakers who rely on inflation progress as a key argument for interest rate cuts.

"The outlook for rising inflation, even with lagging data like rents, will make communication more challenging, which could ultimately make rate cuts more difficult," said Omair Sharif, president of Inflation Insights LLC. "We already have a dissenter, and I think continuing to cut rates in the face of rising CPI could attract more."

Sharif was referring to Federal Reserve Governor Michelle Bowman, who voted against a 50 basis point rate cut in September, supporting a smaller reduction—this is a rare dissent for the Federal Reserve Board, let alone anyone during Powell's tenure. Officials unanimously decided to cut rates by 25 basis points this month, but the outlook for December and beyond remains uncertain.

Powell stated last week at an event in Dallas that the strength of the U.S. economy gives officials "cautious" room to lower borrowing costs. He said that if economic data allows, a gradual approach to rate cuts is wise.

Of course, the Fed's inflation target is based on a separate measure, the Personal Consumption Expenditures Price Index (PCE). The PCE index places less emphasis on the housing sector, which is part of the reason it is closer to the officials' 2% target. However, the PCE calculates its housing measure based on the CPI, so the lagging nature of rental inflation affects both indices.

Michael Feroli, chief U.S. economist at JP Morgan, said: "If its upward trend could break 3%, then I think that would complicate matters significantly."

He was referring to the core PCE measure, which excludes food and energy, and grew by 2.7% in the year ending in September. Economists expect the core PCE to rise to 2.8% in the October data to be released later this month.

The CPI aims to measure inflation for the average consumer and conducts a sampling survey of rent increases for all renters, whether they are renewing existing leases or signing new ones. While current data from Zillow Group Inc. and Apartment List shows that rent growth has slowed or even declined in recent months, the CPI tends to lag behind these trends A paper published last month by the Cleveland Federal Reserve raised another complex issue. The authors found that the decline in U.S. population mobility has exacerbated delays. Therefore, rental inflation will be more sticky, as there are fewer new entrants in the new renter composition.

They wrote, "There is significant concern about the future trajectory of rental inflation, and there is a great deal of uncertainty."