Wonking Out: Virginia Woolf and Core Inflation

If you or someone you know has been looking for a place to live recently, you’re aware that the housing market has gone wild over the past two and a half years. House prices have soared; so have rents.

These developments are important to people’s lives: Keeping a roof over one’s head is a big part of most families’ budgets. They’re also important to economic policy, which is currently focused on bringing inflation down: The cost of shelter accounts for almost a third of the Consumer Price Index and about 40 percent of core consumer prices, excluding food and energy, which are what the Federal Reserve normally uses to guide policy.

So rising housing prices and especially (as I’ll explain) rising rents matter a lot. Which raises two big questions. First, why has housing gone wild? Second, what are the implications for the fight against inflation?

First, a look at the data. These days we have two different kinds of data on housing: private-sector indexes released by online services like Zillow and Apartment List and official numbers from the Bureau of Labor Statistics. Unusually, at the moment these sources seem to be telling quite different stories. Here are three rent indexes, all measuring changes since the pandemic recession began in February 2020:

The B.L.S. series is owners’ equivalent rent — more on that in a moment. What’s obvious is that the private measures show huge rent increases; the official data, not so much. However, this divergence reflects not so much a conflict over the facts as a difference in what the indexes measure. The private firms are looking at listing prices for new renters; the official measure looks at what renters are currently paying, on average. Since many renters have one-year leases, average rents paid tend to lag new rents, notably when the latter are rising rapidly. Over time, we can expect the official series to catch up.

What explains this surge in rents? One explanation I’ve seen in many articles is that rents are driven by the price of houses, which has been rising for a decade — pretty much ever since the mid-2000s housing bubble finished deflating. Low interest rates and limited new supply from homebuilders burned by the crash led to a sustained upward trend in real housing prices; surely, the argument goes, landlords began demanding higher rents to reflect the prices they paid for their buildings.

But this argument doesn’t hold together either logically or empirically. Landlords charge what the market can bear; whatever they paid for their building is a sunk cost, which shouldn’t directly affect the rental market. And the great housing bubble of the 2000s did not, in fact, drive up rents. Here’s the real price of housing and real rents as estimated by the B.L.S. since 2000:

The bubble was huge, although today’s prices are even higher in real terms. But soaring home prices in the 2000s weren’t reflected in rents at all.

So what is going on? The most likely explanation is that the Covid pandemic increased the demand for personal space. Part of this was the sudden surge in working from home, which seems to be sticking even as much of life returns to normal. And working from home is a lot easier if you have enough space to get some privacy and quiet. In a famous essay, Virginia Woolf argued that to write fiction, a woman must have “money and a room of her own.” Remote work isn’t fiction (at least it isn’t supposed to be), and it pays — but a room of one’s own, or at least some personal space, is nonetheless essential.

More generally, the limitations the pandemic created for public life — on sitting in restaurants and coffee shops, browsing through stores, hanging out at the gym and more — may have made living quarters that previously seemed adequate feel cramped. A lot of public life has returned, but there’s a lingering desire for more square footage.

Hence a surge in demand for living space — call it the Virginia Woolf effect — which has probably driven the surge in market rents.

Now, this sounds as if it should be a one-time shock, maybe even one that will partly go into reverse as normality returns. Indeed, the data suggests that rental inflation has peaked, although it remains high:

You may notice that I use annual rates of change here, basically because we don’t have reliable seasonal adjustments that would let me interpret shorter-term movements. But it’s a good bet that the recent rate of rental inflation has come down even more than this figure indicates. And it seems plausible that market rents will plateau, at least in real terms, in the fairly near future.

Official measures of the cost of housing will, however, continue to rise for many months even if this happens. The official measure of the price of shelter combines market rents with an estimate of what homeowners would have paid if they were renting their homes, a number derived from housing that actually is rented. The important point is that both numbers will rise for nine to 12 months even if rents on new dwellings stabilize as leases expire and have to be renewed.

And this may create a dilemma for policymakers. The Fed believes (correctly, I think) that the U.S. economy is running too hot and needs to be cooled off; it uses core inflation as a way to measure that overheating. But housing is a large part of core inflation. And pretty soon we’re likely to have a situation in which official measures of housing costs are rising although we no longer have a hot economy, because official measures are still catching up with the Virginia Woolf effect.

In such a situation, I’d argue, it would no longer make sense for the Fed to maintain tight monetary policy, even though its standard inflation measure is still elevated. But will the Fed be willing to make that judgment? Even if it understands what’s happening, will it worry that taking account of the lagged nature of official statistics will be seen as making excuses and damage its credibility?

Interesting questions, best pondered, I think, at leisure in a room of one’s own.