Rents, inflation and the consequences for interest rates

Our inflation was disappointing, in July and again in August. The rent increase is a major culprit and for the time being our inflation is more likely to increase than decrease. In the United States too, the rent increase is responsible for a large part of the inflation. A considerable moderation of the rent increase can be expected there and that creates room for significant interest rate cuts by the American central bank Fed.

In my opinion, the Dutch inflation in August was disappointing. Although the American inflation figure for August was slightly lower than expected, the core inflation was slightly higher. In both countries, rents play an important role in the inflation figure, although both housing markets are very different in terms of (price) dynamics.

People have to live somewhere and that costs money. A lot of money, in fact. So it makes sense that the costs of living form a substantial part of the price index on the basis of which inflation is calculated. Inflation statistics distinguish between the actual rents paid by tenants and what our CBS calls 'imputed rents of owner-occupied homes'. In the US, the latter is called 'owners' equivalent rent of primary residences'. In both countries, the percentage increase is close to what is measured as rent increase of rental properties. In the Netherlands, rents have a weight of 20,1% in the price index, in the US this is even 34,5%.

Highly regulated
In our country, rents are highly regulated. An annual maximum rent increase is set for the social sector and the increases then take effect on 1 July. In recent years, it was decided to also impose a maximum on rents in the private sector. This maximum rent increase was traditionally linked to inflation, but when that exploded and wage increases lagged considerably behind, the maximum rent increase was linked to wage increases.

Meanwhile, wage growth is exceeding inflation. This year, the maximum rent increase in the social sector was 5,8% and in the private sector 5,5%. According to Statistics Netherlands, the actual increase as of 1 July was 5,5%. Last year, it was 2,1%. Now, the rent increase contributes 1,1 percentage points to inflation, which was 3,6% in August. Excluding rent, our inflation in August was 2,5%. Still above the target that the ECB uses for the eurozone as a whole.

Next year, the maximum rent increase will also be linked to the wage increase. This works with delays and it looks like the maximum rent increase in 2025 will be slightly higher than this year. Of course, the government can decide to link the maximum rent increase to inflation again in 2025. In that case, the maximum rent increase will be lower.

In wage negotiations, the unions naturally assume the actual inflation rate. Given the tightness of the labour market, the well-filled strike funds and the tough stance of the unions, wage increases will remain higher for the time being than was usual before the pandemic. This in turn has upward inflationary pressure. This dynamic suggests that our inflation will remain above that of the rest of the eurozone for the time being.

Much more market forces in the US
The American housing market is much less regulated than ours. Rent formation is, much more than in our country, the result of market forces. In the US, rents follow the development of house prices, albeit with a considerable and difficult to predict delay.

The disappointing August figure for US core inflation was mainly due to rents. In March last year, rent growth peaked at over 8%. The rate of growth then slowed for sixteen consecutive months, but in August rent growth actually picked up again. Actual and imputed rents together recorded a 5,3% year-on-year increase. Given the large weight of rents in the US price index, this means that rents in August were responsible for around 1,8 percentage points of inflation, which was 2,5% in August. If you exclude rents, inflation was only 0,7%. That is a big difference with us. Perhaps this figure is an indication of how far the disinflation process has progressed in the US. Of course, I have to admit that there is little inflation left if you exclude everything that rises rapidly in price, but still…

In addition to the rental component in the price index, institutions in the sector publish figures on the development of rents in new contracts. Based on this, a sharper decrease in the rent increase had actually already been expected, such as that from the inflation statistics. But it is inevitable that the rent increase will fall back in the coming period. In my view, that is quite substantial. If the rent increase halves to 2,6%, then inflation will fall back to 1,6% if all else remains the same. The chance that something like that will happen within, say, nine months seems considerable to me.

Room for significantly lower interest rates
Next Wednesday, the Federal Reserve will meet to discuss its official interest rates. A rate cut is expected. I would be surprised if a 25 basis point cut is not decided. What will happen next is more interesting. If my analysis is correct that inflation in the US will fall below the Fed's target in the coming quarters, then I think there will be room for a significant cut in interest rates. After all, the current level of interest rates is quite restrictive and that is completely out of place in an economy that is only growing very moderately or even experiencing a mild recession and where inflation is below the Fed's target. We'll see.

Closing
The increase in rents has a major impact on inflation, because people (have to) spend a large part of their income on housing. The setback in the Dutch inflation figure for July, which will continue to have an effect over the next twelve months, was largely caused by the increase in rents. For the time being, this will remain the case and the inflation dynamics in our country mean that our inflation is currently well above that of the rest of the eurozone. Due to base effects, our inflation could even rise above 5% in the coming months.

In the US too, rent growth has a major impact on inflation and was the main culprit for the disappointing core inflation figure in August. Unlike in our country, a considerable moderation in rent growth can be expected in the US in the coming months. Based on this, I think that US inflation will fall below the Fed's target within a few quarters. This creates room for significant interest rate cuts by the US central bank.

Hans de Jong

Han de Jong is a former chief economist at ABN Amro and now a resident economist at BNR Nieuwsradio, among others. His comments can also be found on Crystalcleareconomics.nl

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