The conventional wisdom that U.S. inflation will continue to decline as the Federal Reserve maintains high interest rates is being challenged. As businesses and consumers grapple with the costs of pricier loans, the anticipated outcome of reduced spending, decreased consumption, and increased unemployment isn’t quite materializing as expected. Instead, consumers and investors have adapted to the current market environment, and housing — the critical factor influencing inflation — remains largely uncontrolled by the Federal Reserve’s standard tactics.

In a surprising twist, the Federal Reserve’s policies have inadvertently created a paradoxical situation in the housing market, akin to "golden handcuffs." Rather than curbing consumer demand, these actions have unintentionally constricted the U.S. housing supply. Homeowners who secured low mortgage rates before and during the pandemic are now hesitant to sell, thereby creating a deadlock between buyers and sellers, and inadvertently increasing the chances of sustained higher inflation.

U.S. Inflation and the Housing Market: A Twisted Tale

The conventional wisdom positing that U.S. inflation will continue to decline as the Federal Reserve maintains high interest rates is under question. Despite the theory that high interest rates should curb spending and consumption, leading to higher unemployment, the reality seems to be shaping up differently. Both consumers and investors have adjusted to the current market environment, and the key driver of inflation – housing – shows no signs of being contained by the Fed’s usual strategies.

The Housing Market’s Catch-22

The Federal Reserve’s policies have unintentionally created a paradox in the housing market, as they have inadvertently restricted the U.S. housing supply rather than easing consumer demand. Homeowners who secured historically low mortgage rates before and during the pandemic are now hesitant to sell, contributing to the likelihood of persistently high inflation. This stalemate between home buyers and sellers suggests that the current conditions may continue, especially as the chances of a recession recede.

The Elusive Recession

Despite predictions of a looming recession based on the Federal Reserve’s aggressive monetary actions, dwindling consumer confidence, and falling home asking prices, the key ingredients for a recession have not materialized. Investors have adjusted to inflation, consumer confidence is on the rise, and the housing market has entered a stalemate period, with prices remaining high due to the lack of supply. The only remaining argument for a recession is the Fed’s continued aggressive stance against inflation, considered the swiftest monetary policy tightening cycle in over 40 years.

Housing Shortage and the Fed’s Policies

The U.S. housing shortage has its roots in years of underbuilding and is not the result of a single policy or external event. Current estimates of the housing shortage range from 1.7 million to 7.3 million units. The Fed’s policies, intended to control inflation by making borrowing more expensive, are having the opposite effect. Homeowners, locked into low mortgage rates, are reluctant to sell their homes and reset their loans at higher rates, exacerbating the supply shortage.

The Case for Hard Assets

In times of rising interest rates, restrictive credit, and prolonged inflation, investors often turn to "hard" assets like real estate as a hedge against inflation. This strategy serves as a kind of insurance policy against inflation’s depreciating effects. For instance, a Stanford University study found that residential real estate has historically been a safe investment during inflationary periods.

The Path Ahead

To return to 2% inflation, U.S. policymakers should collaborate with state and local governments to incentivize development, thereby reducing the greatest expense for most Americans. However, rectifying the fundamental housing shortage that is driving stubbornly persistent inflation will be a longer process than most investors anticipate.

Takeaways

The current U.S. inflation scenario, heavily influenced by the housing market, challenges conventional wisdom about the Federal Reserve’s role in managing inflation. The housing market stalemate, driven by homeowners’ reluctance to sell due to historically low mortgage rates, has contributed to the persistent inflation. The situation calls for a shift in strategy, focusing on incentivizing development to address the housing shortage. As investors navigate this complex scenario, hard assets like real estate may provide a safe haven in the face of prolonged inflation.