Housing Costs to Keep Inflation Elevated

Peak inflation may be behind us and several factors that contributed to the high pace of inflation have eased in recent months. The cost of some raw materials dropped while cargo rates fell, easing some of the pricing pressures. Fuel costs have fallen substantially, another factor that contributed to the historic inflation trend of the first half of the year. Even as price surges of many of these contributing factors have eased, one of the largest components of inflation indexes has yet to reach full account. The cost of housing (the shelter component) is a large share of inflation indexes as well as a substantial portion of consumer expenses each month. While some of the increase in the cost of housing has flowed through inflation measures, the price increases in housing have been understated and will lead to higher than expected inflation in the coming months. 

The Bureau of Labor Statistics (BLS) utilizes two measures within the shelter component that are part of the consumer price index (CPI), rent of primary residence and owners’ equivalent rent. Both categories are derived from panels of consumers surveyed by BLS. The rent of primary residence is intended to capture price movements of rent paid by actual tenants. The owners’ equivalent rent is based on the panel survey asking homeowners what rent they believe they could receive if they were to rent out their home. There are six survey panels, each is surveyed every six months, meaning one panel is surveyed in January and July, another in February and August and so on. The panel questions attempt to standardize for differences in housing units such as amenities. The BLS has carefully constructed the survey and by weighting by geography and standardizing housing units, the shelter component should generally reflect market conditions. 

Relative to the current pace of housing cost increases, the shelter component seems out of sync with the apartment and single-family home markets, perhaps due to the lag in reporting and the six months schedule. In July, the shelter component of CPI was 5.7% higher than one year ago. Breaking down further, the rent of primary residence category increased by 6.3% while owners’ equivalent rent increased by 5.8%. 
In examining market data, rent growth measures reflect much greater increases than the CPI components. The year-over-year increase in monthly rents reported by another index, the Yardi Matrix, was 12.6% in July, double the 6.3% in the CPI survey. The current delta between the two series is greater than any previous peak and, from 2010 to 2019, the spread between the CPI shelter component and the market-rate rent growth was only one percentage point, highlighting the historical proximity of the two series. 

Of course, some renters do not move frequently or live in rent controlled or subsidized units, but for the majority of renters their monthly rent would increase by the market rate if they were to look for a new apartment as opposed to the CPI rate. Conservative estimates of typical apartment turnover rates are roughly 20%. While this 20%, assuming the household remained a renter, would face the increased apartment rents immediately, the remaining 80% of renter households would experience a lagged adjustment in rents as their leases expired or households moved to new apartment units in the coming months. The lower the turnover rate, the longer it will take for higher apartment rents to fully impact households, and therefore the longer it will take for rent increases to be fully realized within the CPI measurements. 

Similarly, the average single family home rent growth was 12.7% in July, more than two times greater than the shelter component. For many homeowners, accurately determining fair market rent for their home may be difficult while still occupying the home. More than likely, homeowners are influenced by the increase in their home’s value. The surge in home values across the country during the last two years may have driven survey responses higher, but it may take some time for homeowners to increase their assessment of potential rent for their home. Similar to rental apartments, compared with actual single family rents the CPI component is understating the true price gains. 

Regardless of the reason, it is apparent that the cost of housing today according to the CPI surveys is more than 5.7% higher than one year ago whether it is a family looking for an apartment or a single-family home. The CPI survey responses may start to catch up with the elevated pace reported by market participants, leading to higher-than-expected inflation in the coming months. And so, it is more likely that respondents will cite higher costs of housing rather than the opposite. 

The shelter component represents nearly one-third of the total CPI, and an acceleration of this component will have significant impacts on reported inflation. If the shelter component increased by 12% per year, that is just 1% per month, which is not unreasonable given the gains in market rents and home values during the past year, the shelter component alone could add roughly four percentage points to the consumer price index. This means that even if goods inflation decelerates, inflation has the potential to remain much higher than the Federal Reserve’s 2% target. With the Federal Reserve squarely focused on taming inflation, this means that strong measures to slow the economy would be needed in order to reduce the pace of inflation to the 2% range in the near term. This also may mean that higher interest rates are in store, bringing along implications for commercial real estate investments. 

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