Much has been talked about around the lagging nature of CPI inflation, specifically around Shelter.
Due to the fact that shelter inflation comprises the largest weighting in the CPI index at around 30-35%, understanding where this indicator is headed is essential to understanding where inflation is going, and therefore where monetary policy is headed.
Shelter inflation typically consists of two main categories: Owner's Equivalent Rent (OER) and Rent of Primary Residence (RPR). The percentage contribution of each component to shelter inflation can vary over time and by region, but generally, they have a significant weight in the CPI calculation. Here's a breakdown of these components:
Owner's Equivalent Rent (OER): This is usually the largest component of shelter inflation. OER is an estimate of how much homeowners would pay to rent their own homes. It's a hypothetical measure that represents the opportunity cost of owning a home instead of renting it. OER is calculated based on surveys where homeowners are asked how much they think their home would rent for. The weight of OER in the overall CPI can be substantial, often making up around 24% to 30% of the total CPI.
Rent of Primary Residence (RPR): This component measures the actual rent paid by renters for their primary residence. It reflects changes in the rental market and is directly influenced by supply and demand dynamics in the housing market. The RPR typically has a smaller weight in the CPI compared to OER but is still significant, often accounting for about 7% to 10% of the total CPI.
OER is therefore one of the largest components of CPI. One major argument for why inflation should be currently lower than it is is the lagging nature of OER. Typically, the index lags somewhere between several months to over a year. This lag is largely due to the time it takes to survey homeowners, collect the data, and the lease dynamics where rent changes typically occur when leases are renewed or new tenants move in. Since leases often last for a year or longer, adjustments in rental prices may not immediately reflect changes in the housing market.
Because of this lag, when we look at the latest CPI data, we see that while many components of the basket are in outright deflation, OER and shelter continues to provide a “floor” to how low CPI can go:
From this baseline, the debate emerges around where CPI inflation is headed. The assumption is that if OER and Shelter inflation has such a lag, it should slowly continue downward, matching where other components of the basket are already at, allowing the Fed to reach its 2% inflation target.
The issue is that this debate has been going on for over a year now, longer than the average lag of OER.
To understand whether this assumption of OER heading lower eventually still holds water, we must create a simple framework of if/then statements around shelter inflation:
- The primary drivers behind rent prices and the change in them are: the overall change in house prices (affects the principal of a mortgage) and the overall change in mortgage rates (affects the interest rates paid on a mortgage).
- If house prices fall, the overall principal in a mortgage payment will fall, leading to lower monthly payments on new housing purchases
- If mortgage interest rates fall, the interest payments on a monthly mortgage payment decrease, and it also increases demand for housing since the monthly payments are more attainable for more people, leading to higher housing prices.
- If aggregate mortgage payments increase, rents will eventually also increase to make the renting agreement more financially sound for the owner
- If aggregate mortgage payments decrease, rents will eventually decrease since there will be more supply of housing and the equilibrium price of rent will shift lower
Around this framework lies a simple truth: the primary delta driver behind shelter inflation and rents is mortgage rates, though with a lag.
Looking at a simple linear regression between the relationship of a change in 30 year mortgage rates and owners equivalent rent, we see a very strong linear relationship that when 30yr rates increase, OER decreases:
We now know that a change in mortgage rates leads to a legged causal effect on OER.
The kicker now, however, is that 30yr mortgage rates have been falling for months ever since the Fed pivoted:
What this implies is that housing prices and housing activity is set to accelerate if this shift in monetary policy continues. Therefore, the much-talked-about promise of shelter inflation continuing lower could end up being completely missed since by the time that data trickles into OER, housing activity may well have re-accelerated leading to at the very least a floor in OER and therefore shelter inflation, and therefore CPI, and therefore difficult in the Fed reaching its 2% inflation target.
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