Rents are starting to drop, but the way we measure inflation means that we could still end up in a nasty recession next year

Apartment buildings in Manhattan, New York.

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• Rent prices are falling across the country.
• But these declines won't be reflected in the monthly inflation figure for six to 12 months.
• It could lead the Fed to act too aggressively, resulting in a more severe recession than necessary.

Rent prices are dropping and set to fall further. It could be a lifesaver for not only Americans' bank accounts but also the entire US economy as a recession looms.

According to the rental database Zumper, more than half of the 100 US cities measured in its monthly national rent report posted month-over-month price declines in October. Housing experts predict the decline may continue well into in 2023, which would offer relief from the inflation that has gripped the US economy.

But those falling rents won't show up in official inflation figures for a while, and that might make the risk of a recession worse as the Federal Reserve continues its aggressive moves against rising prices.

The issue is that it takes time for lower rent prices to filter into the consumer-price index and other widely watched measures of inflation. That's because the index reflects what renters are paying right now in their leases, which means rapid changes in prices for new leases don't affect most Americans right away.

So even if rental rates continue their descent, this won't show up in the inflation figures until everyone's leases end and renters renew at the lower rate. This could make inflation look worse than it is and cause the Fed to bring about unnecessary economic pain.

Throughout 2022, the Federal Reserve has swiftly raised interest rates to help cool inflation, but its efforts have weighed on the US economy. Given that housing costs, including those for both homeowners and renters, account for roughly one-third of the consumer-price index, falling rents can go a long way in convincing the Fed that inflation is under control. This could prevent hikes and help the likely recession headed for the US be less severe. 

"Right now, it's a race against the Fed," Claudia Sahm, a former Fed economist, told Insider. "The faster those things show up in consumer-price inflation, the faster the inflation steps down, the sooner the Fed will back off."

The Fed 'got burned' by inflation last year. Now it could be overcorrecting.

Sahm said the Fed was well aware of the way rent inflation is measured, adding that it "knows this data better than anyone in the world."

But since the Fed "got burned" last year — when inflation proved not to be transitory after all — she said it seemed to be focusing on the the housing data in the CPI out of an abundance of caution.

In doing so, Sahm said the Fed may have "painted themselves in a corner." She's among several experts who have expressed concern that the central bank isn't factoring in disinflationary forces across the economy — from improving supply chains to slowing rent rates — enough into their policy decisions. 

"The Fed should look at the latest rents being written because that's a better sign of where the economy is headed," she said, adding that housing was the "most backward-looking part of the CPI" and incorporated at an "incredibly slow-moving pace."

"Inflation is coming from continued supply-chain bottlenecks, the energy prices, dealing with the Russian invasion of Ukraine," Elise Gould, an economist for the Economic Policy Institute, told Insider. "There's still some mismatch. I think that some of that's going to come down on its own, so I think the Federal Reserve doesn't have to act so aggressively."

But that doesn't mean substantial action isn't warranted to combat rising prices.

Inflation remains "too high," Sahm said, and housing costs aren't the only category keeping it elevated. Even if current rent rates were reflected in the inflation figure, they might not generate the slowdown needed to persuade the Fed to change course — especially when other price categories could rise and offset the rent decline in the coming months.

Ultimately, the Fed has to weigh the risks between going too far and not going far enough, Sahm said. 

"To the Fed, the balance of risk is that they do too little and inflation stays high, and that's very bad," she said. "But if they do too much, then it's bad too. They just made a choice. It's very strange for them to tie everything on one data point, but that's what they're doing."

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