The Big Idea

An update on shelter costs

| August 19, 2022

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. This material does not constitute research.

The Dallas Fed published a note roughly a year ago predicting a steep and sustained acceleration in the shelter cost component of the CPI.  The piece proved prescient, as rent and owners’ equivalent rent began to accelerate soon thereafter, a key part of the broad-based surge in underlying inflation that began last fall.  The researchers recently updated their analysis, which now shows a higher and earlier peak for shelter costs without much relief until the second half of next year. Shelter alone could keep the Fed at peak funds rate into 2024.

Reviewing the model

The BLS measures shelter costs by estimating the cost of the stream of services that a home or apartment provides.  This equates more to rents rather than home prices, which include an investment component.  However, not every housing unit turns over every month, so the rent and owners’ equivalent rent components of the CPI are correlated to more timely measures like monthly home prices or monthly measures of new signed rent contracts with a lag.

Many, perhaps most, apartment contracts are signed for 12 months.  Consider an example where every rental agreement has a 12-month term, with starting dates evenly distributed across each month of the year.  Now, imagine that rents double for every housing unit on the same day.  A measure of signed rental contracts would immediately show a 100% rise, but the CPI measures would likely rise by about 8.3% for each of the next 12 months—100% divided by 12.

This example illustrates the main reason that the CPI measures, which are also used in the PCE deflator, tend to lag contemporaneous gauges of rents and home prices.  The researchers at the Dallas Fed formalized the relationship, running a series of regressions, and determined that rent and OER inflation tend to lag reported home prices by about 12 to 18 months.

As of June last year, the CPI gauges were still running at a benign year-over-hear rate, about 1.9% and 2.3% respectively. The researchers’ model suggested the measures would accelerate to 3.0% and 3.8% respectively by the end of 2022 and quicken further to 6.9% for both at the end of 2023.  At the time, many found this result to be shocking, and it ran directly counter to the prevailing narrative coming from the FOMC because it suggested inflation would accelerate and stay high for at least two to three years.

Freshening up the results

While the Dallas Fed model got the direction of shelter costs right, the upward trajectory has actually been far steeper than predicted.  Last year’s regressions projected that it would take 18 months just to get up to the 3% vicinity on a year-over-year basis.  In reality, we hit the Dallas Fed end-2022 predictions by the end of 2021!  Updating the models would therefore shorten the lag between home price gauges and the CPI measures.

In addition, home prices continued to accelerate in the second half of last year and into early 2022.  There are signs that the pace of home price increases may be beginning to moderate, but the main input to the model has also been firmer than projected a year ago.

The combination of these two factors yields a considerably different set of results. The updated model now projects a much earlier peak, in May 2023, for shelter costs (Exhibit 1).  That is the good news.  In fact, by the end of 2023, the updated projections are slightly lower than the forecasts from a year ago—6.7% and 6.5%, respectively.  The bad news is that the new peak is much higher than the peak forecasts from a year ago.  The Dallas Fed model now has the year-over-year advances for rent and OER topping out at 8.4% and 7.7% respectively in May 2023.

Exhibit 1: Updated Projections of Rent and OER

Source: Federal Reserve Bank of Dallas.

Implications for overall inflation

Shelter costs represent a massive percentage of the CPI, over 30% of the total and 40% of the core.  The weights in the PCE deflators are markedly lower but still considerable, about 15% of the total and 17% of the core.

Given the weights, we can work out the projected contribution of the shelter costs components to aggregate inflation measures at different times. The contribution to core CPI inflation of rent and OER a year ago, now, and the projected contributions as of May 2023 and December 2023 tells an important story (Exhibit 2).

Exhibit 2: Contributions to Core CPI

Source: BLS, Federal Reserve Bank of Dallas.

The acceleration in shelter costs added roughly 1.5 percentage points to the year-over-year core CPI inflation rate (2.37 minus 0.92) from July 2021 to July 2022.  The core CPI over that period accelerated by about 2 percentage points, from 4.2% to 6.2%, so shelter costs accounted for about three quarters of the pickup.

For the core PCE deflator, the contribution is roughly half as large, so shelter costs only added an additional 0.6 to 0.7 percentage points to the year-over-year core inflation rate and accounted for about half of the acceleration in the core PCE inflation rate, from 3.6% to 4.9%.

Unfortunately, shelter costs are projected to continue to contribute to accelerating inflation going forward. As of May 2023, when the Dallas Fed model has shelter cost inflation peaking, the contribution to the core CPI will increase by another three-quarters of a percentage point to 3.15%.  To put this into perspective, if every other category within the core rises at exactly the same pace over the 12 months ending May 2023 as in the most recent 12 months, then the pickup in shelter costs would push the year-over-year advance in the core CPI up from 6.2% to about 7%.  Clearly, this would be sharply at odds with the relatively benign inflation outlook that is underpinning financial market expectations of easing in the second half of 2023.

Another way to think about the contribution to core inflation from shelter costs is that, if the Dallas Fed model proves correct, then in May 2023 the core CPI would run at 3.2% even if every other component outside of shelter costs was flat, a scenario that seems far too optimistic.

By December 2023, the model suggests that the contributions to core inflation would finally be declining.  However, the December 2023 projections for rent and OER are still slightly higher than the current readings.  If these model results prove accurate, it is hard to see how core inflation can decelerate as quickly and by as much as most economists and market participants currently expect.  Fed officials have begun to suggest that once the policy rate peaks, it is likely to remain steady for a considerable period of time as the Fed waits for inflation to cool back to near the 2% target.  The Dallas Fed model for shelter costs suggests that this wait could be quite extended, probably at least well into 2024.

Stephen Stanley
stephen.stanley@santander.us
1 (203) 428-2556

This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.

Important Disclaimers

Copyright © 2024 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.

In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.

The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.

In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.

Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.

Important disclaimers for clients in the EU and UK

This publication has been prepared by Trading Desk Strategists within the Sales and Trading functions of Santander US Capital Markets LLC (“SanCap”), the US registered broker-dealer of Santander Corporate & Investment Banking. This communication is distributed in the EEA by Banco Santander S.A., a credit institution registered in Spain and authorised and regulated by the Bank of Spain and the CNMV. Any EEA recipient of this communication that would like to affect any transaction in any security or issuer discussed herein should do so with Banco Santander S.A. or any of its affiliates (together “Santander”). This communication has been distributed in the UK by Banco Santander, S.A.’s London branch, authorised by the Bank of Spain and subject to regulatory oversight on certain matters by the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA).

The publication is intended for exclusive use for Professional Clients and Eligible Counterparties as defined by MiFID II and is not intended for use by retail customers or for any persons or entities in any jurisdictions or country where such distribution or use would be contrary to local law or regulation.

This material is not a product of Santander´s Research Team and does not constitute independent investment research. This is a marketing communication and may contain ¨investment recommendations¨ as defined by the Market Abuse Regulation 596/2014 ("MAR"). This publication has not been prepared in accordance with legal requirements designed to promote the independence of research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. The author, date and time of the production of this publication are as indicated herein.

This publication does not constitute investment advice and may not be relied upon to form an investment decision, nor should it be construed as any offer to sell or issue or invitation to purchase, acquire or subscribe for any instruments referred herein. The publication has been prepared in good faith and based on information Santander considers reliable as of the date of publication, but Santander does not guarantee or represent, express or implied, that such information is accurate or complete. All estimates, forecasts and opinions are current as at the date of this publication and are subject to change without notice. Unless otherwise indicated, Santander does not intend to update this publication. The views and commentary in this publication may not be objective or independent of the interests of the Trading and Sales functions of Santander, who may be active participants in the markets, investments or strategies referred to herein and/or may receive compensation from investment banking and non-investment banking services from entities mentioned herein. Santander may trade as principal, make a market or hold positions in instruments (or related derivatives) and/or hold financial interest in entities discussed herein. Santander may provide market commentary or trading strategies to other clients or engage in transactions which may differ from views expressed herein. Santander may have acted upon the contents of this publication prior to you having received it.

This publication is intended for the exclusive use of the recipient and must not be reproduced, redistributed or transmitted, in whole or in part, without Santander’s consent. The recipient agrees to keep confidential at all times information contained herein.

The Library

Search Articles