Higher Interest Rates Can Lead to Higher Rents!
I don’t generally recommend particular researchers, although I’ll point to someone who has a sharp idea when it attracts my attention. In the latter category, I have to point to the latest from Jay Parsons – an article entitled “Could Higher Rates Re-Accelerate Rent Inflation? Maybe.”
It’s always useful to read out-of-consensus analysis. Reading the 122nd article about how AI is going to put us all out of work and cause spiraling deflation isn’t very useful. When it comes to forecasting housing and rent inflation, another regurgitation of the high-velocity rent indices that capture a tiny part of the people paying rent (only the people with new rent contracts), or that confuse the effect of interest rate increases on sales with the effect on prices, mostly just cause me to glaze over and skim past.
But this article is interesting, mainly because it highlights something that is universally true and yet almost-as-universally misunderstood. And that is the notion that higher interest rates cause disinflation by dampening demand.
I’ve written about this until I’m blue in the link – interest rates do not have any useful causal relationship on subsequent inflation. But the article from Jay Parsons lays out the reason very clearly, in the context of housing. It’s often proposed that interest rate increases affect the economy most directly through housing, because higher interest rates cause higher mortgage rates and higher mortgage rates cause less demand for housing, and less demand for housing causes less building, etc. The demand channel rules.
Except…that completely ignores the supply channel. This was one part of the enormous COVID policy mistake – yes, by shutting in consumers you crush demand. But that’s not deflationary because you’re also crushing supply. And when you flush lots of money in the system at the same time, well…the results were predictable. Parsons highlights this effect on the housing channel – low interest rates trigger lots of building, and high interest rates tend to impair building. That is, interest rates operate significantly on the supply side.
And that makes sense to me. If I am buying a house and I have to make a 30-year decision on an interest rate, then higher interest rates will definitely reduce the amount of home I buy. But the primary decision to buy a home is not generally based on interest rates…the amount of home may be. On the other hand, as a homebuyer I also know that my commitment isn’t 30 years. It’s as long as I remain in the home, at most, and if interest rates drop at all I know it’s very easy to ratchet my rate down. The interest rate I am paying today is the maximum rate I’ll ever pay (assuming we’re talking about a fixed rate, of course). I’m not saying that higher interest rates don’t impact the demand for homes. I’m just saying I don’t think it’s as huge as we have been led to believe.
On the supply side, though, the return on equity for a builder is (a) the margin per home, times (b) the number of times the portfolio of homes built turns over in a year, times (c) the leverage applied to the portfolio. Okay, that’s just the DuPont equation and it’s true for all businesses, not just builders. Higher interest rates slows sales, and increases the cost of leverage, so builders definitely respond negatively to higher interest rates. And they respond by building fewer houses.
Whether that turns into rent inflation in 2027 and 2028, we will have to wait and see. My landlord-cost model is already anticipating rent inflation reaccelerating some, but not getting out of hand. It’s nice to see someone deep in the housing market coming to the same out-of-consensus conclusion.
Going back to the more-general case: this is more widely true than is typically appreciated. Because all of us are consumers, but not all of us are manufacturers, and because Keynes focused lots more on aggregate demand as a driver of the business cycle, somehow people tend to gloss over the supply side. It’s fascinating. It is not at all intuitive to me that increasing interest rates should lower inflation, since increasing rates affects both supply and demand and which dominates is indeterminate. So it doesn’t surprise me to see no lead relationship between rates and inflation; what surprises me is that people are surprised by that. (Similarly, the idea that interest rates contain an ‘inflation risk premium’ that the borrower must pay to the lender is baffling. Both sides have inflation risk – one to higher inflation and one to lower inflation. So why does only one side get a risk premium? In my opinion the risk premium should sometimes be positive, sometimes negative, and I can’t reject the hypothesis that it should be indistinguishable from zero. But I digress.)
So don’t forget about the supply side. That also matters!
