U.S. inflation dipped below 3% in July for the first time since 2021, though stubborn housing costs have kept price increases higher than monetary policymakers would like.

Consumer Price Index (CPI) data released Wednesday showed a 0.2% inflation bump between June and July, in line with economists' predictions, and a 2.9% uptick year over year. But after moderating slightly in June, shelter costs rose 0.4% and accounted for nearly 90% of the overall month-to-month increase.

In the Twin Cities metro, overall inflation rose 1.3% in the past two months and 3.5% year over year, outpacing the national trajectory. The shelter index increased 1% in the latest two-month period and 5.9% over the year.

Part of the problem is interest rates — which Federal Reserve officials are holding at a 22-year high to temper consumer spending and bring inflation down — have strained the housing market by dissuading buyers and stalling much-needed new construction. The median home price in the Twin Cities region was $390,000 in June, up 1.8% year-over-year, according to Minneapolis Area Realtors (MAR). Average monthly rents in the metro reached $1,500 in the second quarter, Marquette Advisors reported, as demand outstrips supply.

Nationwide, new home sales fell more than 11% between May and June, according to a MAR report of U.S. Census Bureau data. Between July 2023 and June 2024, pending home sales in the Twin Cities were down 2.2%. Meanwhile, Housing First Minnesota reported in July builders in the metro pulled 452 permits for new single-family homes, a 1% year-over-year increase, and permits for 150 multifamily units, a whopping 303% decline.

"The macroeconomic forces that have influenced demand — and they have, interest rates have moved a segment of demand to the sidelines — that's happening concurrently with a 15-plus-year undersupply of housing," said Housing First CEO James Vagle. "To understand the housing market and to understand how housing prices continue to outpace other market segments in an inflation environment, you have to look at the undersupply. We simply don't have enough homes."

The year-over-year inflation picture is rosier. The shelter index rose 5.1% from last year, the lowest since March 2022, and overall year-over-year inflation is within reach of the Fed's 2% target. Though the personal consumption expenditures (PCE) price index is the central bank's preferred inflation gauge, policymakers take a variety of measures into consideration.

"The trend continues to make its way down, so we'll see what comes next," said Erick Garcia Luna, regional outreach director at the Minneapolis Fed. "That's great, given how the year started."

The shelter index is largely based on rental prices, with the cost of homeownership represented as "owners' equivalent rent." It also includes lodging away from home and rental and household insurance. Because it takes time for rental costs to change as leases run their course, economists expect about a yearlong lag before shelter inflation shows up in the data, though that has yet to happen.

"It's been a really strange environment. Usually, when the Fed changes monetary policy, the housing market is the first sector to get hit," said Scott Anderson, chief U.S. economist and managing director at BMO Capital Markets. "We haven't necessarily seen that yet because I think the rates went up so quickly on mortgages, and people had bought a lot of houses during the pandemic, locked in those low mortgage rates, and they're very reluctant to give those up."

The 5.25% to 5.5% federal funds rate has driven the 30-year fixed mortgage rate up from less than 3% in 2020 and 2021 to roughly 7%. Fed officials are widely expected to make a rate cut in September, though, from their perspective, the benefits of a slow housing market in the fight against inflation likely outweigh the squeeze that high rates have put on new construction, said Tyler Schipper, an associate economics professor at the University of St. Thomas.

"It is kind of two steps forward, one step back," he said. "But I don't think, from the Federal Reserve's perspective, they would see lowering interest rates as a way to solve housing inflation."

Government policy changes allowing a greater array of housing to be built are a more likely solution, Vagle said. He pointed to recent reforms in Minneapolis, including eliminating parking minimums for new construction and allowing duplexes and triplexes on all residential lots.

Mayor Jacob Frey on Wednesday proposed a 2025 budget that includes money for building affordable housing. On Tuesday, St. Paul Mayor Melvin Carter floated a $7.4 million housing plan as part of his budget address and asked the City Council to scale back the city's rent control law to spur housing construction.

Also Tuesday, the U.S. Department of Housing and Urban Development (HUD) announced $100 million in local grant funding Tuesday aimed at spurring housing construction nationwide.

"When we build at scale, when we do a surge of building to overcome the undersupply, we see a direct response in price point moderation," Vagle said, "which is great for consumers."

Staff writer Jim Buchta contributed to this report.