Written by: Rebecca Chen

The Federal Reserve may have a new problem: The housing market’s recent reversal could keep inflation from coming down as much as the central bank wants.

The latest data shows that more homebuyers are coming into the market, while for-sale inventory continues to shrink. As a result, home prices — which affect a major factor in the government’s inflation measure — have unexpectedly ticked higher month over month since the beginning of the year.

This development could prompt a change in the Fed's course of action, even after it said this week that it plans to take a more wait-and-see approach to future interest rate hikes.

"The hope has been for a while that the rent component and the shelter component of housing, which makes up roughly 40% of the CPI basket, would begin to come down because housing has been slowing down," Torsten Slok, chief economist at Apollo Global Management, told Yahoo Finance. "But the problem is housing is actually beginning to show signs of moving higher."

This Wednesday, April 12, 2017, file photo shows a home for sale, in Natick, Mass. (AP Photo/Steven Senne, File)

Housing prices and inflation

Housing costs contribute 44% in the overall goods and service basket used to calculate the Consumer Price Index (CPI), the main gauge for inflation. The housing component is made up of two categories — rent and owner equivalent rent (OER), or the rent homeowners would pay for similar homes.

"The weights in the basket are a reflection of your spending patterns. And therefore, housing has gone up so much that the weight of housing has increased in the last few years because people are now spending even more money on housing rather than on restaurants, travel, and hotels," Torsten explained.

For instance, the shelter category in CPI climbed to 8.2% year over year in March 2023, the biggest 12-month gain since June 1982 and much higher than the range it's been at in the last decade. March's rate is also four times higher than the Fed's target rate of 2% per year for overall inflation.

While home price growth is not directly used in CPI calculations, past trends have shown it strongly correlates with housing inflation, according to the Federal Reserve Bank of Dallas.

"If the housing market rebounds and if people are out there buying homes, that means that rents are also going up again because there's more demand for housing," Torsten said.

Inflation is 'just not coming down'

Home prices do appear to be reversing.

The S&P CoreLogic Case-Shiller U.S. National Home Price index unexpectedly climbed 0.2% in February month over month, ending a seven consecutive-month decline. The Federal Housing Financing Agency (FHFA) released a measure with an even greater monthly growth of 0.5% in February. And seasonally adjusted home prices increased by 0.45% in March, the highest since last May, based on data published by Black Knight.

Home prices have remained elevated due to low inventory week after week. And a series of rate increases, which marked the Fed's most aggressive campaign to curb inflation since the 1980s, has only helped to lower home inventory even more. Right now, many potential sellers are holding back on listing their homes, because they want to keep their current lower mortgage rate.

At the same time, "traffic of prospective buyers is going up,” Torsten said. "And here's the real kicker: The number of offers for properties sold is up."

Data provided by Apollo Global Management found that the average number of offers received per sold property ticked up from 2.2 offers in December 2022 to more than 3 offers in February.

The recent activity appears to be putting a floor on home prices, which could keep inflation at its stubborn rate of around 5%, much higher than the Fed's target rate.

"You can look at different measures of CPI core or PCE core, but the conclusion is the same: On core CPI, inflation is 5%," Torsten said. "And it's just not coming down."

'Notable exceptions'

Even though home prices are rising, that doesn’t necessarily mean the shelter portion of the CPI will follow. The correlation, while high per the Dallas Fed study, is not absolute.

"In general, the two move together as you expect, but there are notable exceptions,” John Sabelhaus, a fellow at Brookings Institution and former chief of the microeconomic surveys section at the Federal Reserve Board, wrote to Yahoo Finance. “During the early 00s housing boom, house prices shot up, but rents (and thus owner equivalent rents) did not."

Average US rent recorded its first year-over-year decline in March, falling 0.4%, according to Rent.’s latest findings. Month over month, rent has dropped each of the last four months, the opposite of how home prices are trending. However, the 0.01% monthly decline in March was the smallest of the last four drops.

Apartments are seen undergoing construction on February 28, 2023 in Austin, Texas. (Photo by Brandon Bell/Getty Images)

But rental prices could face further downward pressure due to an influx of new supply coming online soon, said Lawrence Yun, chief economist of the National Association of Realtors.

“There is a high chance that rents will turn the corner because apartment construction is at a 40-year high, with a very robust number of new empty units to hit the market,” Yun wrote to Yahoo Finance.

While Fed Chair Jerome Powell said this week that housing has been one of the sectors to react quickly to interest rate changes, “it will take time, however, for the full effects of monetary restraint to be realized, especially on inflation.”

The central bank plans to take “a data-dependent approach” to determine future monetary policy moves, the chair said this week, which likely will include watching the direction of home prices.

"I think the housing markets largely are still stalled," Sabelhaus told Yahoo Finance. "I think keeping the housing sector weak has always been one of the most direct ways monetary policy affects the economy."

Rebecca is a reporter for Yahoo Finance and previously worked as an investment tax certified public accountant (CPA).