Analysis: Falling rental vacancies seen stoking core CPI

WASHINGTON (Reuters) - Growing demand for rental properties as the economy strengthens is set to lift underlying U.S. inflation gauges, but it will still be a while before the Federal Reserve starts tightening monetary policy.

High rental vacancies have weighed on the core consumer price index, which excludes volatile food and energy prices, and economists now see this anchor slipping loose.

In the fourth quarter of 2010, the rental vacancy rate fell to 9.4 percent -- the lowest since the second quarter of 2007 -- from 10.3 percent in the July-September period.

Rental costs constitute about 40 percent of the core CPI, which rose 0.8 percent in the 12 months to December, staying close to a record low. Core CPI is a gauge of underlying inflation.

"Where the disinflation has come from is through shelter costs -- primarily rents, and owners equivalent rent. That's because of the big housing price declines, the effect that had on rents, and high vacancy rates," said Dean Maki, chief U.S. economist at Barclays Capital in New York.

"That is changing dramatically right now."

The Bureau of Labor Statistics uses owners equivalent rent, or OER, to measure the amount homeowners would pay to rent or would earn from renting their property.

Joseph LaVorgna, chief U.S. economist at Deutsche Bank in New York, said the annual core CPI could grow more than 2 percent this year.

"In fact, we are already seeing early evidence of accelerating rents," LaVorgna said, noting that owners' equivalent rent rose 1.2 percent over the past three months.

"With the vacancy rate falling, these growth rates are likely to accelerate -- potentially by an appreciable amount."

While other central banks in advanced economies are raising red flags on inflation following a spike in commodity prices, the Fed has not shifted from its view that core inflation rates remain uncomfortably low.

Fed Chairman Ben Bernanke told lawmakers on Wednesday that overall inflation was still quite low and longer-term inflation expectations remained stable.

Even with the anticipated surge in the annual core CPI rate, this view is unlikely to change much. This is because Fed officials prefer the core personal consumption expenditures price index as a gauge of consumer inflation because it takes into account changes in spending habits by households.

The core PCE index in December rose 0.7 percent from a year ago, the smallest rise since records began in 1959.

FED TO STAY PAT

"We can see a little bit of a heat up in core inflation numbers before the Fed really has to move. My expectation is the Fed doesn't move in terms of raising the fed funds rate until March 2012," said Robert Dye, senior economist at PNC Financial Services in Pittsburgh.

Dye said the U.S. central bank would first need to consider whether the strength in the economy warranted changes to its much criticized $600 billion government bond-buying before weighing the issue of raising interest rates.

Fed officials still consider the pace of recovery as not vigorous enough to tackle a 9 percent unemployment rate and are leaning heavily toward the completion of the program.

The economy grew at a 3.2 percent annual pace in the fourth quarter and all indications are that the momentum will continue through much of this year.

Economists say this is one major reason to expect a further reduction in the number of empty rental properties on the market as some of the more than 8 million people who lost their jobs during the recession find work.

The housing-led recession, which was the longest and deepest since the Great Depression of the 1930s, saw millions of homeowners losing their homes and forced many Americans to move in with family and friends.

"Now that the labor market is firming a little bit and the fear of losing a job is going down, some people who have lived with parents or friends may decide they are now in a position to go and rent their own apartments," said Harm Bandholz, chief U.S. economist at UniCredit Research in New York.

In addition, the housing market rout and sour economy, caused a sharp reduction in the construction of rental apartments, which means a shortage is slowly building up as the economy gathers more steam.

"Housing starts for multifamily buildings between 2009 and 2010 were about a third of what we had seen before the crisis," Bandholz noted.

Also pointing to a deceleration in rental vacancies is the homeownership rate, which in the fourth quarter touched its lowest level since the first three months of 1998.

(Additional reporting by Mark Felsenthal; Editing by Neil Stempleman)