Everyone knows that the Fed is intensely focused on core services ex-housing inflation to determine future course of monetary policy. This chosen path makes two assumptions – core goods disinflation continues unabated and the lagged effects of reducing shelter inflation start to factor into the CPI calculation by mid-2023.
The central thesis is that core inflation, which currently is still elevated at 5.6%, is on track to moderate to around 3.5% – 3.7% by end 2023. A nominal Fed Funds rate of approx. 5.1% (assuming they hike in May) leaves the real interest rate in the region of 1.4% – 1.6% – which is deemed to be sufficiently restrictive monetary policy to help achieve inflation goals.
Firstly, goods disinflation is not a slam dunk. But that story is for another day. Today we talk about shelter inflation.
Shelter, and within Shelter – Owner’s equivalent rent of residence – a has large weightage in the overall CPI calculation.
I will explain this concept a bit further. The shelter service that a housing unit provides to its occupants is the relevant consumption item for the CPI. The house itself is an asset and house price changes don’t factor into the CPI. In other words, the purchase price of a home, renovation costs, etc are treated as investments and not consumption items. Most of the cost of shelter for renter-occupied housing is rent. For an owner-occupied unit, most of the cost of shelter is the implicit rent that owner occupants would have to pay if they were renting their homes, without furnishings or utilities.
Latest Core CPI recorded for Mar 2023 was 5.6% and headline CPI was 5.0%. Shelter inflation came in at 0.6% m-o-m and 8.2% y-o-y. The one-month annualized rate of shelter inflation is 7.2% and the 3-month annualized number was 8.4%. Historical CPI shelter inflation average has been 3.7% and the Fed is assuming we will start seeing a taper down to this rate by mid-2023.
This belief that shelter inflation will start tapering by mid 2023 is based on more timely private measures of rent. For eg. the Zillow Observed Rent Index (“ZORI”).
Current Rentals vs Shelter CPI
Previous studies of correlations between private measures of rent and CPI rent inflation have shown a lag of 18-24 months. An FRBSF paper released in Jan 2022 had accurately predicted the rise in CPI shelter inflation based on a model that takes into account increases in current asking rents and the CPI rent index. The model predicted that CPI rent inflation will increase by an additional 3.4% for both 2022 and 2023. While asking prices of current rents have reduced, they are still close to 6.0% on a y-o-y basis. See graph below. The lag of 18-24 months works both on the way up and down. For instance – In the early days of the pandemic, market observed rents fell sharply, but the shelter component of CPI was slow to react.
Source: Zillow, BLS, TCB calculations
House Price Growth vs Shelter CPI
Another point of consideration is the correlation between changes in house prices and the OER component in CPI shelter inflation. A study conducted by the Dallas Fed in Aug 2021 showed that house price growth has led inflation by somewhat less than 2 years. The study confirmed the relationship by computing the correlation between current rent inflation and past and future house price growth which was the strongest at an 18 month lag. Given that house prices really peaked only in Mar / Apr 2022, it is likely that the effect will make its way into OER inflation only by early 2024. In other words, an annualized rate of 3.0-3.5% shelter inflation seems more a 2024 scenario instead of a 2023 one.
Source: Case Shiller, BLS, TCB calculations
What matters most though:
However, while the lag with which the shelter component in CPI will come down is key, what is even more important is to note current developments in the US residential market. Here is a summary –
- The sharp rise in mortgage rates has perversely resulted in a lower inventory of existing homes for sale.
- While affordability has taken a hit because of higher mortgage rates, buyer demand (from the extreme wealth creation of the past 3 years) remains resilient.
- This has caused a shift to more buyer activity in the new homes market. New home sales have posted a m-o-m gain for the past 5 months in a row!
- Home price growth, on a m-o-m basis, has accelerated in the past few months – indicated by almost all private measures of the US residential market. While this is seasonal in nature, it is an increase nonetheless.
- The NAHB Index – a gauge of home builders demand – has increased for 4 consecutive months.
- ITB, the iShares Home Construction ETF, is 16% up year-to-date and is only about 10% off its all-time high recorded in Dec 2021!
- The Zillow Observed Rent Index showed asking rents climbed 0.5% m-o-m in March. While this increase is seasonal in nature, it is an increase nonetheless and only slightly lesser than normal for this time of the year.
The longer Shelter inflation stays elevated the more concerned the Fed will grow about its ability to reach its desired inflation target. This story is not yet over…