The Big Idea
Revisiting shelter costs
Stephen Stanley | November 10, 2023
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.
The slowdown in shelter cost inflation this year has contributed significantly to the slowdown in overall core inflation relative to 2022. But with home price indices and gauges of rents turning higher in recent months, the ongoing deceleration in rent and owners’ equivalent rent (OER) may not persist for much longer.
Establishing a Framework
Researchers at the Dallas Fed have done a nice job over the past several years building a framework for analyzing and forecasting trends in shelter costs. Historical data suggest that the shelter costs component of the CPI tends to be correlated with gauges of home prices and rents with a lag of about a year. There is some logic to this, as the CPI is attempting to measure rents and implied rents for all residents, not just for those who entered a new lease in a given month. Given that the predominant rental contract length is one year, for any 1-time shift in rents, it would take about a year for the CPI components to fully reflect the change.
This historical relationship allowed researchers at the Dallas Fed to predict in 2021 that after the spike in home prices and rents, shelter costs would take off in 2022. That is exactly what happened, with the CPI components peaking on a month-to-month basis in late 2022.
A lagged slowdown
Home prices and rent indices turned negative for a time in late 2022. In fact, the S&P CoreLogic Case-Shiller 20-city home price measure posted month-to-month losses for eight straight months beginning in July 2022. However, since turning up again in March, the gauge has surged, rising by nearly a full percentage point a month since May.
Similarly, the Zillow Rent Index slid on a monthly basis in the final three months of 2022 but rebounded at the beginning of 2023 and has risen by over 3.5%, or at nearly a 5% annualized clip, since the beginning of 2023.
In any case, the decline in contemporaneous measures of home prices and rents in late 2022 is feeding through into the shelter costs component of the CPI now. After rising by as much as 0.8% per month late last year and early this year, the rent and OER components have been posting gains of 0.4% to 0.6% a month since March. As a result, the year-over-year advance has moved from a peak of 8.2% in March and April to 7.2% in September.
Chair Powell and other officials have treated the likelihood of cooling in shelter costs as an ace in the hole for them. In fact, the main reason that Powell broke out shelter costs as one of three distinct components of core inflation in his analysis of price trends this year has been that he was confident that the gauge would be moving lower, in light of the lags discussed above. Fed officials have consequently focused on the core services ex-housing piece, comfortable that core goods inflation had already descended and that housing inflation would decelerate soon.
The Dallas Fed research department published an update of their model findings in June this year. Their model, using the CoreLogic rent index to predict shelter costs 12 months forward, called for the shelter costs gauge to decelerate on a year-over-year basis to 5.7% in the first quarter of 2024.
While that result sounds encouraging relative to the latest reading of 7.2%, the arithmetic is actually not especially uplifting. If we assume the 5.7% prediction applies to the 12 months ending March 2024, then we already have half of that 12-month period in hand—that is, readings from April through September. Shelter costs for that 6-month period ran at a 6.0% annual pace. To get to the Dallas Fed’s projection of 5.7% for the 12 months through March, shelter costs would need to run at a 5.4% pace over the next six months to get the two 6-month periods to total up to the 12-month projection. That implies monthly increases over the next six months that average 0.44%, only a few basis points lower than recent readings. In fact, the August rise in shelter costs was even smaller than that at 0.40%.
In short, as things currently stand, the deceleration seen already in the monthly readings is about all we can hope to achieve, at least in the near term.
Looking further ahead
If we look further ahead, things get even worse. Over the past six months, the Zillow rent index has increased at a 5.5% annualized pace, up from the September 2023 year-over-year advance of 3.2%. What we have seen in recent months in the rental market—and home prices are sending the same signal—points to, if anything, a reacceleration in the shelter costs component of the CPI beginning in the spring of 2024, about the timeframe that financial market participants currently expect inflation to be calming to the point that the Fed will be preparing to begin easing. Money market futures currently imply that the first ease may come around mid-2024.
However, the best-case scenario, based on the Dallas Fed model, would appear to be that shelter costs continue to rise at roughly the current pace of 0.4% to 0.5% a month through next summer. The risk skews toward even higher figures. It is difficult to see core inflation getting back to anywhere near the Fed’s 2% target if shelter costs, which represent about 40% of the core CPI and nearly 20% of the core PCE deflator, are running at over double that clip.