How High Mortgage Rates Fuel Inflation

It’s costlier to move, so fewer houses are on the market. Less supply means higher prices and rents

By Tomas J. Philipson. Excerpts:

"As Keynesian logic goes, rate hikes should cut demand and thereby reduce inflation in markets that rely heavily on credit, such as housing and cars. Such industries contribute heavily to inflation measures—housing costs make up about 40% of the core consumer-price inflation. But housing costs are difficult to measure. Inflation indexes aim to measure the consumption cost of housing, captured by rents and, for homeowners, imputed rents."

"Housing prices are trending upward this year, partially because rate hikes suppress the supply of housing as well as the demand. Some 40% fewer existing homes are for sale than before the pandemic. That’s because about 90% of outstanding mortgages are financed at fixed low rates. No wonder owners don’t want to sell.

When rate hikes lower supply more than demand, it raises rather than lowers housing prices. Meantime, as higher prices and financing costs deter would-be home buyers, rental demand and prices have increased as well. As a result, rate hikes may be inflationary rather than deflationary for 40% of core CPI."

"The Case-Shiller housing price index is focused on such existing homes and excludes new construction. Despite persistent rate hikes for close to a year and a half, this index is up during 2023."

"Some 75% of car sales are for used cars and owners who are sitting on car loans at favorable rates. This reduces supply at the margin and contributes to the rise in used-car prices we have seen throughout 2023.

Given that housing prices are up for 2023, housing-cost inflation is forthcoming, as it is positively related to such prices with a lag. This suggests a continuation of sticky core inflation. But fighting it with more rate hikes may make it even stickier."