Shelter component exposes the Fed's ‘last mile’ battle with inflation

The January US consumer price index (CPI) data came in stronger than expected with core month-on-month figures coming in at 0.4 % (0.3% expected) and year-on-year figures at 3.9% (3.7% expected) but unchanged from December’s 3.9% print.

Looking closer at the individual components of CPI shows us that goods inflation continued to decline in January, with used car and truck prices (-0.36%) providing a useful barometer. Core goods inflation has now seen seven monthly declines in the past eight months. Services inflation, however, has remained stubbornly sticky, led by a 1.6% leap in hospital services prices, a 1.4% increase in airline fares, and lodging costs jumping 1.8%.

Digging deeper, a significant contributor to inflation data can be found within the “shelter” component of the services basket. Shelter is comprised predominately of a) owners’ equivalent rent (OER), b) rent of primary residence (Rent), with some smaller contributions from c) lodging away from home, d) tenants’ and household insurance, and e) rental equivalence for vacation homes and timeshares referred to as “unsampled owner’s equivalent rent of secondary residences”. 

It is important to note that shelter represents a greater weight in the CPI basket (approximately 36%) when compared to the PCE data base (approximately 18%), which is the Fed’s preferred inflation measure. OER, accounting for the majority of the CPI contribution (27% of the 36%), is defined by the US Bureau of Labor Statistics (BLS) as “the implicit rent that owner occupants would have to pay if they were renting their homes, without furnishings or utilities”. In other words, the amount of rent that would have to be paid in order to substitute a currently owned house as rental property. Whilst Rent (7.7% of the 36%), can be classified as "the actual rent charged by those who rent their primary residence". 

To make it a little clearer and, according to the BLS, the expenditure weight for OER is based on a survey that asks consumers who own their primary residence the following question: “if someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?” For the calculation of Rent, those consumers who rent their primary residence are asked: “what is the rental charge to your household for this unit including any extra charges for parking?”. January saw an unexpected 0.56% leap in OER, the biggest increase since last April, while Rent rose only 0.36%, the smallest increase since August 2021.

This differential is interesting. Given the downtrend in primary rent inflation, we note that the ‘zillow observed rent index’ has been growing at an increasingly slower rate (declining trend) for the past eight months and turned negative in October of 2023 through to December, only to show a 0.13% increase in January 2024. While actual rents have cooled, they haven’t yet posted significant declines. High mortgage rates continue to fuel rental demand and some landlords continue to offer one-time concessions. Home prices continue to rise faster than rents, which of course fuels rental demand. 

However, the asking price for rents have been declining due to a jump in apartment supply. According to data from the St. Louis Fed, the rental vacancy rate was 6.6% in both the third and fourth quarters of 2023, which is now comparable to the vacancy rates in late 2019 (prior to Covid). But don't mention that data to a New Yorker where vacancy rates are closer to 1.4%. Furthermore, data from Redfin highlights that the number of recently completed apartments is near its highest level in more than 30 years, and the number under construction is just shy of its record high. Given these trends, specifically the downtrend in primary rents and the increase in apartment supply, the current gap between OER and Rents should narrow, which should see an improvement in the shelter component of inflation data.

The Fed’s fight against inflation and its 2% target is facing headwinds that is being referred to as “trouble with the last mile”. The latest CPI data has pushed back yet again expectations of an early Fed rate cut. The persistence of high inflation, particularly in the services sector, has adjusted market expectations to be more in line with the Fed’s projections, pushing the anticipated timing of rate cuts further back to more likely June or July.  The market is now pricing in ~100bps of cuts for 2024, more in line with the Fed’s projection of 75bps of cuts and significantly below the 170bps of cuts priced in at the beginning of the year. 

Rental prices have been trending lower while mortgage rates are still high (latest Freddie Mac 30-year fixed-rate mortgage is quoted at 6.64%). Whilst the Fed has made significant progress in lowering inflation over the past 18 months, caution for “the last mile” is warranted. Progress is being made and, although the monthly data may continue to be bumpy, it is encouraging to see supply/demand becoming more balanced within the shelter component of inflation data.