Where Rents Go, Will Inflation Follow?

Alexander Shevlyagin, a 25-year-old Seattle computer-software manager, says he was shocked to learn in May that his rent was rising to $1,305 a month from $935. "My building manager told me, 'Hey, we're almost at full occupancy,'" Shevlyagin says. "He said he signed the same place I have on a different floor for the new rates, so someone thinks that this is reasonable. I don't consider it reasonable."

The travails of renters like Shevlyagin could become a concern for the Federal Reserve. For now Fed Chairman Ben Bernanke and his colleagues say they will hold rates at record lows, since the slack from 9.1 percent unemployment will help subdue core inflation.

Not everyone agrees. "They should have looked at rents," says Maury Harris, chief U.S. economist in New York at UBS Securities (UBS), whose team was the most accurate inflation forecaster in 2009 and 2010, according to Bloomberg calculations. "They're putting too much weight on the 'slack is all that matters' theory." Bruce McCain, chief investment strategist at the private-banking unit of KeyCorp, says housing has become "a contributor to inflation, and it continues to rise." He's telling clients to adjust their portfolios to counter long-term inflation.

Rent represents about 40 percent of the core consumer price index and made up almost a quarter of April's 1.3 percent rise. Apartment rents rose 5 percent in the 12 months through April, says researcher Axiometrics. First-quarter cash flow at AvalonBay (AVB), which owns 50,000 apartments nationwide, climbed 18 percent from the year before. "Landlords have a couple years of runway to have pricing power over their tenants," says JPMorgan Chase (JPM) analyst Anthony Paolone.

Rental yields (the rent divided by the property price) will climb in 2011 to the highest level in more than 20 years, predicts Paul Dales, senior U.S. economist in Toronto for Capital Economics. "I'm sure it's something the Fed is watching, but I wouldn't be too surprised if they haven't factored in such a rise," he says. "It's possible the Fed may be surprised there."

While rents weren't mentioned in the minutes of the Fed's April meeting, its Apr. 13 Beige Book report on economic conditions was peppered with stories of rising rents in Boston, Chicago, and New York. On June 6 the New York Fed posted on its website a brief item: "The fact that the traditionally more stable components of inflation, such as rents, are the ones driving its increase could be a source of concern." It's time, says UBS's Harris, to raise rates. Otherwise rent increases could trigger inflation that will be hard to stop. "If you have a healthy rate of core inflation," he says, "you don't have any business having the federal funds rate under 25 basis points. That's ridiculous."

The bottom line: Some analysts say the Fed may have to pay more attention to rents, which accounted for a quarter of the recent 1.3 percent rise in inflation.

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