Will the Residential Recovery End Disinflation?

Summary

• The ongoing residential investment recovery is too small to discernibly impact housing supply and cap housing inflation.
• Yet it is adding to aggregate demand and could create resource pressures.
• The risks are finely balanced. On one hand, the US housing shortage supports a strong residential recovery. On the other, Fed support has been much more limited than in previous recoveries.
• I do not see the residential recovery ending disinflation for now, but this could change.

Market Implications

• I continue to expect continued disinflation and the first Fed cut in June, in line with market expectations.

Residential Recovery Will Not Cap Housing Costs

Residential investment is recovering. In 2023 Q4, it grew 2.9% and contributed 11bp to GDP growth of 3.2%, which aligns with pre-pandemic trends. In this note, I consider the impact of the recovery on inflation through two channels: housing costs and resource pressures.

We start with housing costs. The outperformance of housing inflation relative to other services predates the pandemic (Chart 1).

Largely, the outperformance reflects underinvestment in housing following the GFC (Chart 2).

In theory, faster residential investment should increase housing supply and lower housing inflation. In reality, no obvious relationship exists between residential investment and housing inflation (Chart 3).

This reflects several factors, including:

• Residential investment is small relative to the housing stock: post-GFC, new home starts peaked at 1.8mn in December 2021. Yet that is less than 1.5% of the total number of homes in the US.
• Housing inflation correlates better with wages than with residential investment or home prices. This reflects that home prices and residential investment influence the supply of housing over the longer run, while wages influence consumers’ short-term ability to pay.

Furthermore, residential investment has become more correlated with house prices. This suggests homes are increasingly bought more for investment purposes and less to secure shelter services.

Overall, the residential recovery seems unlikely to cap housing costs. However, it could create resource pressures.

Housing Recovery to Add to Overheating Risks

Disinflation and the improved current account balance show US aggregate demand and supply are finding a better balance. Yet signs of resource pressure exist: the budget deficit is the largest outside a recession since the 1960s, household savings are near the historical lows of the mid-2000s, and corporate investment as a share of GDP is the highest since the 1960s.

Against this backdrop, a strong pickup in residential investment could add to resource pressures, especially if not offset by weaker non-residential investment or strong savings.

The risks of a pickup in residential investment are finely balanced. Compared with the GFC, more favourable factors this time include the housing shortage mentioned above, stronger household balance sheets, and a generally stronger labour market and household income recovery.

Furthermore, this time the housing market recovery is driven by new home sales (Chart 4). Because mortgages are generally not transferable, and most borrowers have borrowed at rates far below current market rates, Fed tightening has effectively locked homeowners in their current homes.

Consequently, existing home sales have collapsed, and a greater share of home supply has been sourced from newly built homes. New home sales have more of an impact on residential investment than existing home sales since sales of existing homes are not associated with new housing investment. Rather, they record a change of ownership for an existing asset.

Additionally, an increase in homes under construction does not signal oversupply since both housing starts and completions have stabilized at close to pre-pandemic levels (Chart 5). Rather, the stock of unit under construction is likely to be absorbed over time.

Against these tailwinds, Fed support has been tepid, so far.

Fed Support Key to Outlook

Due to the unusual nature of the pandemic recession, Fed support to the housing market has been more limited than in previous recoveries.

In previous business cycles, the Fed would hike, which would trigger a contraction in residential investment followed by a recession. The Fed would then ease, and residential investment would recover strongly (Chart 4).

For instance, residential investment growth between the 1990 recession and the GFC was massive. This reflected the limited impact of Fed easing on employment and inflation. In turn, this kept the FFR on a downward trend and led to growing household leverage, rising home prices, and soaring residential investment.

This time, the recession/Fed easing sequence has been different. First, the recession was triggered by an economy-wide furlough rather than Fed tightening. The 2020 residential investment contraction lasted only one quarter against 5-22 quarters in previous recessions.

Second, the Fed eased so much it triggered an unprecedented expansion in residential investment, even though this expansion was not preceded by a contraction. This spike reflects that the Fed was targeting massive unemployment but, in the process, boosted financial asset prices, including home prices, which eluded a strong residential investment response.

Third, with an inflation acceleration, the Fed then had to tighten, which triggered a sharp but short-lived contraction. Residential investment peaked in 2021, fell sharply in 2022, and troughed in 2023 Q2. This limited contraction partly reflects the strong recovery.

The Fed move to an easing bias in January 2024 has seen only a small decrease in mortgage rates. This suggests only a limited recovery in house prices and therefore a continued sluggish residential recovery (Chart 7). In turn, this supports continued economic stabilization and disinflation.

However, should mortgage rates fall further (say if markets expected the Fed to ease more than the 3.5 cuts priced), home price inflation could accelerate and elicit a stronger residential recovery. This highlights the difficulty of fine-tuning Fed policy precisely enough to engineer a soft landing.

Market Consequences

Paradoxically, an increase in the economy’s supply side can be inflationary because it first requires an investment that adds to aggregate demand. Even though the US has a housing shortage, faster growth in residential investment could tip the economy into overheating and end disinflation.

This does not seem to be happening now, but I am monitoring the risks closely.

I continue to expect disinflation and therefore the Fed to start cutting in June, in line with market expectations.

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Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.

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(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)