With all eyes on inflation these days, it’s helpful to dig into some of the biggest contributors for perspective on where inflation might be heading. The cost of “shelter” is far and away the highest weighted component of CPI, clocking in at more than a 30% weight of the total CPI number. Interestingly, the shelter component of CPI isn’t so straightforward a measurement – that is; it’s not something like a strict measure of home price appreciation. At the moment, shelter inflation is still increasing at an increasing rate. Can this continue? Let’s dig in to some of the more interesting nuance of shelter inflation, and look for signs of what might be in store for this sizable component of CPI and other key takeaways.
CPI Shelter Inflation – the Nuts & Bolts
To begin, let’s discuss how CPI calculates shelter inflation. Shelter inflation is measured as a function of rental prices – both what people are actually paying for rent currently, and what homeowners think they could rent their property for were they to do so. A bit unexpected, right? Actual home prices are nowhere to be found. Moreover, this data is collected via survey – an actual questionnaire sent out to people asking them these very questions.
Going further, historical data shows that changes in rental prices actually lag home sale prices by approximately 12-18 months.
So, what do we take away from this methodology? Perhaps most obvious is that increases in home prices, like the surge that happened in the earlier/middle stages of the pandemic era, didn’t immediately translate into any impact on inflation. Not until rental prices began to surge in the latter half of 2021 did shelter inflation finally started to make its way into CPI.
But even then, the impact was muted as first. This is another wrinkle in the CPI methods – not all people surveyed had necessarily seen their rents increase. Indeed, as rental periods are often for 1-2 year terms, the CPI survey data wouldn’t capture the fullness of rising rents until all respondents had renewed their leases at conceivably higher rates.
With this in mind, it makes sense that shelter inflation is still increasing at an increasing rate. The lag of rental price appreciation behind home price appreciation, as well as the lag in capturing all people with rental price increases, causes shelter inflation to essentially creep in over time. The most recent shelter inflation data was up 0.7% month-over-month (8.4% annualized), and up more than 6% year-over-year.
So, where do we go from here? Without a doubt, the increase in new rental prices has slowed in 2022 vs 2021.
Even better, home prices appear to have turned down somewhat, and new rental prices actually went negative in September on a month-over-month basis (partially a seasonal pattern, but this didn’t occur during the robust pricing in September 2021).
Unfortunately, we still have the potential for higher-priced rental renewals to keep upward pressure on shelter inflation given the methodology of CPI. Even with any new rents leveling off or declining, this might not translate meaningfully into the data for many more months.
Which leaves us in a bit of a conundrum – CPI shelter inflation is arguably a backward looking perspective on actual current inflation in the shelter market. Thus, the Federal Reserve, in their quest to combat inflation, is stuck focusing on data that may offer a fairly dated perspective on the inflationary reality (given that its largest weighted component operates with some serious lag). So as housing, a large piece of the US economic picture, is beginning to show cracks, the Fed is humming right along in raising interest rates. It would seem that this disconnect is a recipe for poor Fed policy, which may be overly tight for an extended period. This may leave the US vulnerable to a potentially deeper period of recession or slow growth in the wake of the Fed’s policy. Indeed, it would seem that a more timely revised methodology to CPI shelter inflation could help better articulate the inflationary reality in the US today.