INFLATION RATES CONTINUED THEIR march upward in May, climbing toward the top of the Federal Reserve's comfort zone and almost certainly securing another increase in a key interest rate.

The Consumer Price Index (CPI), the most frequently cited measure of inflation experienced by consumers on a day-to-day basis, increased at an annualized rate of 0.4 percent in May, following a 0.6 percent jump in April. The “core CPI,” which subtracts the costs of food and energy, rose 0.3 percent in May. “We're beginning to build up a record that's disturbing,” says John Tuccillo, a real estate industry consultant. “The impact will be higher interest rates, if nothing else, which makes it a problem for the real estate and home building sector.”

Many economists agreed that the pace of inflation would be enough to prompt the Fed to raise its short-term Federal Funds rate another quarter-point, to 5.25 percent, at its June 29 meeting. (This issue of BUILDER went to press before the Fed's scheduled meeting.) Such an increase would ripple through to the housing sector, causing higher rates on adjustable mortgages; as of June 15, the one-year ARM rate had already risen to 5.66 percent, up from 4.25 percent last June.

The inflation rate threatening to further slow the housing market is, in part, caused by it: Increases in rent prices accounted for a large share of the CPI jump in May. In some cities, upward of 20 percent of the rental stock has been converted into condominiums. Fewer apartments, higher home prices, and rising mortgage rates have driven the demand—and the prices—for rentals higher.

Jim Glassman, senior economist at JPMorgan, sees the pressure from rent prices on inflation as a temporary distortion. Con-do-conversion projects will continue to revert back to rentals, he contends, leading to lower rent prices. “The owners can't afford to let [the units] sit idle,” he says. “We may see signs of rent prices going the other way by late summer or early fall.”

That won't be enough to protect home building from an inflation-related hit, however. The Producer Price Index, a measure of inflation during production, also rose in May. Overall, construction materials and components climbed 1.2 percent during the month and 7.8 percent since May 2005, with residential materials increasing about 8 percent over the year. The combination of higher interest rates and rising materials costs leads Ken Simonson, chief economist of the Associated General Contractors of America, to believe the housing slowdown will be sharper than he'd expected. “It will affect all types of house, to some extent,” he says.

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