The Big Idea
Rising home prices, rising rents, rising inflation
Stephen Stanley | September 10, 2021
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Home prices have surged over the last 12 months with intense demand for homes spurring nearly 20% appreciation. Various gauges also indicate rents are running up double digits from a year ago. But the shelter costs measure used in the CPI and PCE deflator is estimated a little differently and has barely begun to inch up. New research from the Dallas Fed, however, suggests shelter costs are poised to pick up rapidly over the next two years and boost an important component of inflation.
Rent and owners’ equivalent rent
After inflation surged in the late 1970s and early 1980s, the Bureau of Labor Statistics made a pivotal change in CPI calculations. BLS determined that owning a house consisted of an investment coupled with consumption of a stream of services. Rather than simply measuring home prices in the CPI, the BLS moved to a rental-equivalence concept. The idea is that statisticians are looking to measure the cost of procuring the stream of services that come with living in a residence, regardless of whether the occupants are renting or owning. Home prices may swing wildly up or down, but that is regarded as an asset price, not a cost of living in a house or apartment.
While it is straightforward to gauge apartment rents under that framework—there are plenty of explicit prices available for rentals—it is a trickier proposition for owned homes. There is a market for rentals of single-family homes, but it is far thinner in many places than the rental market for apartments. That may change over time since there is a growing market in many areas where investment firms buy a sizable number of single-family homes for rent. In any case, the BLS measures rents for a sample of rented homes that are similar to the universe of owned homes to come up with “owners’ equivalent rent” (OER).
One key point is that not every housing unit changes hands every month. Even if home prices or rental lease agreements are surging, the implied rent is not changing every month for every unit. One consequently would expect the rent and OER measures within the CPI to be less volatile than home price gauges.
Finally, to offer context for the importance of shelter costs, the combined weight for rent and OER in the CPI is more than 30%, while for the core CPI, the weight is roughly 40%. The weights are smaller for the PCE deflator but still large—about 15% and 17%, respectively. So even though shelter costs are not nearly as volatile as higher-profile line items like gasoline, used cars, airfares and others, the trends for shelter costs are still vital in determining headline and core inflation because of their large weight.
Predicting shelter costs
Researchers at the Dallas Fed examined the historical relationship between home prices and shelter costs in a recent paper published on the bank’s website. They compared the 12-month change in the Zillow house price index to the 12-month change in the PCE measures for rent and OER. The rent and OER PCE price figures are largely derived from and vary little from the corresponding CPI measures.
Their first step was to find the best lagged relationship. Testing the correlation at various lags, they found that the current house price increase is most strongly correlated to the PCE measure of rent 18 months later and for OER, the best correlation is 16 months later. The correlation coefficients at those time lags were around 75%.
Next, given such a high correlation, the researchers created a regression model to predict rent and OER going forward based on home prices. Their results were eye-catching. The PCE rent gauge was projected to accelerate to 3% on a year-over-year basis by the end of 2022 and to nearly 7% by the end of 2023, while the corresponding results for OER were similar, at 3.8% and 6.9%.
If the 2023 estimates come to fruition, shelter cost inflation would be the highest in more than 30 years. Compared to the average readings for rent and OER from 2017 to 2019, the 6.9% increase in shelter costs would boost the headline PCE deflator by 0.5 percentage points, while the core PCE deflator would be lifted by 0.6 percentage points.
That magnitude of contribution may seem modest in the current context, with a handful of categories surging and producing outsized readings. However, presuming that the various pandemic-related dislocations as well as current supply chain issues are well behind us by the end of 2023—both the run-ups and the reversals—this simple model projection suggests that shelter costs alone would contribute just over 1% to the PCE deflator at that time. For the Fed to hit its 2% inflation target, the other 85% of the aggregate would have to be rising at only a 1.1% pace. While that is conceivable, it does not seem likely, especially given other current influences, like rising wages, that make take quite some time to work their way through the price-setting process.
While Fed officials continue to debate how transitory the recent inflation spurt will be, these research findings suggest that when inflation does settle back to a more stable trend, it could be at a pace noticeably higher than the FOMC would prefer.