Fed Study: The biggest driver of inflation is expected to ease by the end of the year

According to the latest research from the Federal Reserve Bank of San Francisco, as the largest contributor to U.S. inflation, housing costs are expected to ease by the end of this year and return to pre-pandemic trends by 2025.

Economists Oscar Jorda and Aren Yalcin from the San Francisco Fed wrote in a research report published on the bank's official website on Tuesday, "We expect housing inflation to continue to decline in the coming months." They cited a model that includes indicators measuring the balance of housing supply and demand.

The U.S. Bureau of Labor Statistics uses new lease agreements, average rents for existing leases, and costs that landlords must pay when renting out properties to measure housing costs. These costs account for a significant portion of the Consumer Price Index (CPI), so higher-than-expected readings earlier this year led Federal Reserve officials to maintain higher interest rates for a longer period to curb rising living costs.

The decline in core commodity prices is the main driver of cooling inflation, while rents are sticky.

However, housing costs differ from the prices of other goods and services, which decrease as high borrowing costs suppress demand. Housing supply may be negatively affected as higher interest rates make construction costs higher, leading to an increase in housing costs.

The two economists wrote, "Overall, rental prices will eventually slow down, but the pace of rental price slowdown is much slower compared to other goods and services, as the supply of other goods and services is less sensitive to interest rates."

Jorda and Yalcin used data from the Census Bureau on the gap between new household formations and completed housing units, as well as the number of new homes under construction and rental listing data from Zillow, to construct a model for predicting housing inflation. They also considered past values of housing inflation, core CPI excluding food and energy, unemployment rates, and the Federal Reserve's benchmark interest rate.

"Taken together, these indicators suggest that housing inflation will continue to decline to more traditional levels next year," they said.

According to the model, the U.S. housing inflation rate is likely to fall to 2% by the end of this year and then return to the pre-pandemic average level of 3.3% by spring 2025. The authors of the study emphasize the direction of the forecast rather than the numerical predictions or time frame of the model