The consumer price index report for July showed the smallest back-to-back monthly increase in two years. This is welcome news in the battle to tame inflation, but the even better news was buried deep in the report. There, it was revealed that rising shelter costs accounted for a whopping 90% of the increase in the CPI. Why is that good? Because the category is notoriously out of date and most likely already in decline, making the moderate inflation data even more benign in reality.

Let’s start with what shelter costs are and how they are measured. The Bureau of Labor Statistics calculates this metric – which accounts for about a third of CPI – by looking at changes in actual rents and something called owners’ equivalent rent. That second part is essentially a survey-informed assessment of how much homeowners think they could get by renting their home.

What this all means is that a backward-looking metric is what’s driving the CPI numbers. How so? We know that the rents that landlords are asking for new leases are already in decline. It takes a while for the drop to affect the data, as most tenants have one- or two-year leases. A recent report from the Federal Reserve Bank of San Francisco suggests that shelter-cost inflation peaked around April at around 10% on a year-over-year basis. As more leases turn over, that rate should continue to drop through the rest of this year and into 2024, reaching zero in May, according to the report. Indeed, more timely data from private-sector sources such as Apartment List already show a year-over-year decrease in rents!

This is undeniably good news for the economy because it means the Federal Reserve may not need to raise interest rates again to get inflation back down to its 2% target, or about half of what it is currently. And no more rate increases boosts the odds that the economy avoids a damaging recession that puts millions of Americans out of a job. At the least, Bloomberg Economics says the Fed can avoid hiking rates when policymakers next meet in the second half of September.

There are two important caveats to consider. First, even though inflation has moderated, prices on goods from food to cars to housing remain elevated. The National Association of Realtors said Tuesday that its quarterly Homebuyer Affordability Index fell to a record low in the period ended June 30. Second, the expectation that future rents will decline is driven in large part by more supply coming online. At just under a million units, multifamily housing starts are at a record high, having soared from around 600,000 units before the pandemic. But actual completions have lagged well behind, perhaps because developers are deciding that borrowing costs are too steep to make finishing the projects profitable.

In that sense, perhaps the key to taming inflation would be lower rates – at least for developers – if it means more housing. Even then, economists have long known that sky-high rents in places such as New York and San Francisco were products not just of strong job markets but also of restrictive building policies that make it difficult to add supply in the form of more affordable housing. Navigating the maze of required permits and approvals at various stages of a project doesn’t make things any easier. As a result, the many obstacles that developers face often means that it only makes economic sense for them to build luxury apartments.

Perhaps the model for the way forward can be found in the Minneapolis-St. Paul area. Bloomberg News reports that the Twin Cities is the first major area to see its overall inflation rate drop below 2%. Minneapolis-St. Paul has been able to temper rent increases by fostering supply after effectively eliminating single-family zoning laws in 2019. The entire area became fair game for building duplexes and triplexes. As a result, Minneapolis rents have grown by only 1% since 2017, according to a recent report by the Pew Charitable Trusts.

So maybe the key to taming inflation isn’t a recession and stifling interest rates, but smarter government and monetary policy. At the highest levels, the Fed should definitely slow or even end its rate increases and allow the declines in rents that are already happening make their way through the data instead of waiting to actually see it in the data before deciding not to act. And at the local level, governments should promote ways to increase the housing supply without upsetting the fabric of their communities. That one-two punch from above and below can give Americans the strong, low-inflation economy they deserve.

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