As Housing Inflation Looks Set to Cool Further, so will Headline Inflation

The shelter component of the Consumer Price Index (CPI) grew by 0.3% from the previous month in October and 6.7% year over year, marking the largest factor in the monthly increase in the core index that excludes food and energy, the Bureau of Labor Statistics (BLS) reported Tuesday.

Headline inflation rose 3.2% in the 12 months through October, a deceleration from the 3.7% annual gain in prices, but still high compared to the Federal Reserve's long-term target of 2%.

Owner's equivalent rent (OER), the hypothetical rent people would pay for their own property and indirectly takes into account home price growth, plays a big role.

OER makes up 74% of the shelter index, or contributes 24.42% to overall CPI. Numerous serious studies have shown that housing inflation numbers in CPI and PCE reports have been lagging 12–18 months behind actual market rents and home prices:

● An October 2022 Bureau of Labor Statistics paper found that "rent inflation for new tenant leads the official BLS rent index by 4 quarters."

● A 2022 study co‐ authored by Larry Summers found that, "Year over year growth in OER, either in the CPI or PCE, correlates most strongly with the 16- and 12‐ month lags of home prices and private sector rents, respectively."

● A Boston Fed study uses market information from older leases to project (due to lags) that "CPI shelter will grow 5.9 percent from September 2022 to September 2023 and then 3.9 percent over the subsequent 12 months. These numbers suggest that CPI shelter will remain [artificially] elevated."

The following chart shows how BLS methodology effectively uses changes in housing prices 18 months prior (blue line) to drive the Owner's Equivalent Rent component of the CPI. Housing prices peaked in June 2022 and declined until January 2023, but the BLS is assuming that shelter costs are still rising at a 6.7% annual rate, thus artificially boosting the overall CPI, according to Scott Grannis, former Chief Economist at Western Asset Management.

EY chief economist Gregory Daco added that it takes time for home prices and rents to filter through to the CPI index, but both have been cooling significantly, leading to more disinflationary pressure as we move into 2024 on the shelter front.