Rising Rents Could Be the Spark That Reignites Inflation

Vacancy rates have been declining at apartments around the U.S., and that means that rents are climbing -- and likely will head even higher in the next year.
Vacancy rates have been declining at apartments around the U.S., and that means that rents are climbing -- and likely will head even higher in the next year.

Vacancy rates have been declining at apartment buildings across the U.S., sending rents sharply higher. And those higher rents could translate into a doubling of the inflation rate this year.

According to the U.S. Census Bureau, vacancy rates at residential buildings fell to 9.4% in the fourth quarter of 2010, down from 10.3% in the third quarter. "That was basically one of the largest quarterly declines ever," says Joseph LaVorgna, chief U.S. economist for Deutsche Bank.

For the full year, the decline amounted to 1.3%, the second-largest on record. "In the grand scheme of things, 9.4% is still relatively high, but you have to go back to 2003 to find where we were lower," LaVorgna says.

How Rents Figure Into Inflation

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Any shortage of supply usually translates into higher prices, and rents have proven no different. Rents for primary residences have grown 2% in the last three months, while overall rents are up 1%. "Given where vacancies are, these rental trends are going to accelerate," LaVorgna says.

Higher rents not only hurt the pocketbook, but also increase the inflation rate. Retirees, who get annual Social Security raises based on the inflation rate, have seen no hikes for the past two years because inflation is so low. This makes life doubly difficult for retirees whose rents are going in the opposite direction.

For sure, food and gas prices have also been skyrocketing this year. They hit an all-time high in January, according to the U.N. Food and Agricultural Organization, and have helped to ignite protests in Tunisia, where the president was ousted, and in Egypt, where the president is under mounting pressure to resign.

But those commodities aren't included in the so-called core consumer price index that the Federal Reserve uses to decide whether or not to increase interest rates. But housing makes up 40% of the core inflation calculation.

Thanks to the rise in rents, LaVorgna now predicts inflation will double to 1.6% in 2011 from last year's 0.8%. That would still remain well below Europe's relatively raging 2.4%. But LaVorgna believes the inflation rate in the U.S. could hit 2% by the end of the year, which is the level the Federal Reserve is targeting.

Preventing Deflation

The Fed has been worried that inflation has been so low that prices might fall into a downward spiral known as deflation, a phenomenon similar to what has crippled Japan's economy for more than a decade. "Two percent inflation would be good because we won't have to worry about deflation anymore," LaVorgna says.

Until those worries are removed, the Fed is unlikely to consider raising interest rates. But market forces seem to be pushing them higher, causing big losses for investors in fixed-income securities, like bonds. America's low interest rate policy has also helped push down the value of the dollar on international markets.

Now, falling vacancy rates and rising rents could start pushing inflation higher, adding to the dismay of bondholders as well as renters.