This paper was prepared as part of a Brookings Institution research project on supply-side issues affecting inflation. Find out more about this project here.
Abstract
Rents surged during the post-pandemic period. Given the substantial weight of rent in inflation measures, this surge became a focus for monetary policy. In this paper, we consider whether that focus was appropriate. We argue that, under certain conditions, monetary policy may be more optimal when it places less weight on shelter inflation than its share in consumer expenditure. This conclusion follows from the interplay of stickiness in rents, relatively inelastic housing supply, and search costs as a mechanism for rationing excess demand. We explain why shelter inflation in the U.S. may overstate the importance of rents, at the expense of other factors such as house prices and mortgage costs that affect the cost of owning but do not directly affect the measurement of shelter inflation. We clarify when monetary policy might “look through” structural reforms to boost housing supply. Furthermore, we assess the relationship between monetary policy and housing costs. On one hand, lower interest rates reduce builders’ financing costs. On the other hand, more accommodative monetary policy increases demand for housing (along with other goods and services), which in turn puts upward pressure on the price of housing. We find that, on net, more accommodative monetary policy increases the cost of housing. We discuss these arguments in the specific contexts of the 2000s housing boom and bust and the post-pandemic surge.
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