IIn this episode of The REconomy Podcast™ from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi break down what’s happening with inflation, explaining why it has proven to be stickier than most expected, the importance shelter inflation plays in overall inflation, and how inflation may trend in the months ahead.

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Listen to the REconomy Podcast™ Episode 91:

“That gives us some confidence that, based on industry rental price data, shelter inflation should come down as that lag catches up. And we're not the only ones that know about this. The Federal Reserve knows about this lag, so it should make them feel good that shelter inflation will drag overall inflation lower, which may give them some confidence to cut interest rates.” – Odeta Kushi, deputy chief economist at First American

Transcript:

Odeta Kushi - 
Hello and welcome to episode 91 of The REconomy Podcast, where we discuss economic issues that impact real estate, housing and affordability. I am Odeta Kushi, deputy chief economist at First American and here with me is Mark Fleming, chief economist at First American. Hey Mark, we have got a very big day coming up in the economics world.

Mark Fleming - Big day, indeed. Hi, Odeta. It happens actually eight times a year, and I get excited every time, but we might be the only ones who do. It's FOMC day. As a quick refresher, the Federal Open Market Committee, or FOMC for short, is the VIP club of the Federal Reserve where all the big decisions about interest rates and monetary policy get made.

Odeta Kushi - That's right. And, while every FOMC meeting is important, the one coming up in June is extra special because it comes with projections about the economy and monetary policy. It's like getting a sneak peek at the Fed's crystal ball.

Mark Fleming - Of course, the Fed projections are just that -- projections, not promises. I do find it interesting, though, that they don't use the word forecasts.

Odeta Kushi - I think that's intentional.

Mark Fleming - Yeah, haha, forecasts have a bad name. And, of course, in part, this is important because of the vaunted dot plot. The Fed's dot plot records each Fed official's forecasts -- sorry -- projection for the federal funds rate. The dots reflects what each U.S. central banker thinks will be the appropriate midpoint of the fed funds rate at the end of each calendar year.

Odeta Kushi - And all eyes will be on that dot plot. And, of course, all of the other projections as well, such as GDP, unemployment and, of course, inflation. Now in the last dot plot projections from March, the Fed penciled in three 25-basis point rate cuts, yet the latest market expectations, according to the CME FedWatch tool are that there will only be one maybe two 25-basis point rate cuts this year. So what's up with that?

Mark Fleming - Well, it certainly has a lot to do with the fact that inflation is remaining stickier than we had hoped for this year, which has prompted the Fed to signal that it will remain in a 'higher for longer' interest rate position. In other words, cut less or cut later, or some combination of both.

Odeta Kushi - And, it's that inflation stickiness that we'll be talking about in today's episode. Specifically, we're going to discuss one of the main reasons that inflation has been so sticky and, unfortunately it has to do with housing.

Mark Fleming - Say it ain't so. Our industry is the reason for the stickiness? 

Odeta Kushi - Yes, well, sort of. Let's break it down. First, we'll start with how inflation is even measured. There are two primary metrics for measuring inflation, the Consumer Price Index, or CPI, for short, and the Personal Consumption Expenditures, or PCE. The PCE is the Fed's preferred measure. And, if we want to get really specific, the Fed really cares about the core PCE, which measures the changes in prices of goods and services purchased by consumers excluding the volatile food and energy sectors. Now Mark, will you briefly explain the primary differences between the CPI and the PCE.

Mark Fleming - Yet again, the econ-splainer. Remember that from many episodes ago?

Odeta Kushi - I do. 

Mark Fleming - But wait, wait. This is my own portmanteau. The primary difference lies in their scope and calculation methods. The CPI focuses on out-of-pocket expenses directly paid by consumers for a fixed basket of goods and services. In contrast, the PCE covers a broader range of expenditures, including those made on behalf of consumers, like health care services paid by employers. And it allows for changes in consumption patterns over time.

Odeta Kushi - So, the PCE accounts for changes in consumer behavior, such as when someone substitutes, let's say beef for chicken because beef has become too expensive.

Mark Fleming - That's right. And that's an important component of that, substitution of goods, as different season prices change. So, it's more reflective of actual consumer spending patterns compared to the CPI, and generally more comprehensive.

Odeta Kushi - Well, that sure explains why the Fed prefers it, but markets still react to the CPI. And it's important to note that the CPI and the PCE generally move together, even if their methodological differences mean that the rates of inflation will differ. In fact, I checked their correlation coefficient is 0.965. Or about 97%. 

Mark Fleming - Yes, three significant digits again. That's a pretty strong correlation, no doubt. Now, we mentioned the two indices because shelter has a different weight in each of them. The cost of shelter, the service that a housing unit provides its occupants, constitutes about a 33% share of the the headline Consumer Price Index, and a 42% share of the core CPI making it the largest expenditure category in each. Shelter also makes up a large portion of the Personal Consumption Expenditure Price Index, accounting for 15% of the headline PCE and 17% of the core PCE. And to make things more interesting, the CPI shelter component is what's used in the PCE, just with the lesser weight. 

Odeta Kushi - I had to, I had to. 

Mark Fleming - So, movements in CPI shelter inflation are an important determinant of how either one of the broader price indices will move. Let's focus on CPI shelter for a moment and how that's measured. CPI shelter is made up of two primary components -- direct cost to renters of renting a home, and cost to owners of living in a home. The latter is known as owners equivalent rent, or OER. But why would we use OER? Why don't we just measure house price changes using some kind of repeat sales index? Fair question. And that's because the objective of the index is to capture the change in the consumption value of a home, not the change in the value of the home itself. We consume shelter services from the home, the roof over our heads, hence the name not the asset value. So my shelter consumption as a homeowner should be measured as how much I would have to spend to consume the service of shelter as a housing service provided by my home.

Odeta Kushi - And the BLS gets their data on shelter prices by collecting rent data for over 40,000 residences through personal visits or phone calls. The sample is divided into six panels, each of which is sampled every six months on a staggered basis. So, the first sample panel is sampled in January and July, the second in February and August, and so on and so forth. Since rents don't usually change frequently, comparing samples over six months allows the BLS to pick up more meaningful changes. One panel is is replaced each year to make sure that the housing sample is representative. And the BLS does adjust for changes in the quality of housing over time. 

Mark Fleming - Buit, what about for the owners equivalent rent, or OER?

Odeta Kushi - Well, they use rent data to impute OER based on rents for comparable rental housing in the area.

Mark Fleming - Now, that does indeed sound complex. 

Odeta Kushi - I mean, it is. It's got to be tough to find rental housing that's comparable to owner-occupied units.

Mark Fleming - And the main difference between CPI rent and OER is that OER excludes utilities because owners pay for utility services separately. So CPI shelter inflation is primarily driven by the changes in the rental market.

Odeta Kushi - All right, so we're looking at rents. But here's one nuance. It's measured with a lag compared with market-based measures of rents. CPI shelter typically lags market rents because CPI shelter updates slower because it's measuring the change in rent for the stock of all housing units, while market rents capture only new rentals. Because only a portion of leases turnover each year, changes in the stock of all housing unit market rents are reflected slowly as more rents more new rents enter and old rents leave the stock over time. Therefore, CPI shelter lags the flow of new rents in the market with a lag of about 12 months or so.

Mark Fleming - And listeners, you may have noticed that this is a veiled bathtub analogy. If you go back to the prior episode, you'll know what we're talking about. Annual shelter inflation, according to the CPI, peaked at 8.2% in March of last year, but has since decelerated to 5.5% in April. Meanwhile, the Zillow Observed Rent Index, that's the flow on the margin, peaked in February of 2022, at roughly 16%, but has since slowed to about 3.6% in April.

Odeta Kushi - Well, that's actually good news. And that gives us some confidence that, based on industry rental price data, shelter inflation should come down as that lag catches up. And, you know, we're not the only ones that know about this. The Fed knows about this lag, so it should make them feel good that shelter inflation will drag overall inflation lower, which may give them some confidence to cut rates. But shelter inflation hasn't come down quite as quickly as everyone had hoped. And one of the reasons why shelter inflation may be slower to reflect real time rent data is that more renters are renewing their leases instead of buying a home, given the interest rate environment that we're in, given the affordability constraints that potential buyers are facing. And that could increase the time that it takes for lower rents from newly signed leases to show up in inflation. But I mean, it's just a matter of when, not if, right? 

Mark Fleming - Not so fast. 

Odeta Kushi - Uh oh, what?

Mark Fleming - Well, we are beginning to see some modest re-acceleration in those real-time rental prices in the Zillow Index. Ever so slight but, along with other industry insights, there are reasons to believe that it's something to watch.

Odeta Kushi - All right, that's a good point. The most recent trend in market rents as a leading indicator of overall shelter inflation is indicating increasing or at least not further decreasing rent inflation. That's a future headwind to overall shelter inflation returning to normal.

Mark Fleming - And, no surprises, his is what happens when you don't build enough of a good that is in high demand -- shelter inflation headwinds, picking up strength.

Odeta Kushi - Which is interesting, given that there are so many apartments under construction right now, over 900,000 units, which is quite high from a historical perspective. This has, and should continue to, put downward pressure on rents. But it seems like maybe demand may have picked up too, and is absorbing some of this new supply. Why do we think that is?

Mark Fleming - Yeah, you would have thunk all those multifamily apartments being brought online would be enough. But, when in doubt...actually, no doubt here. It's about demographics. Generation Z is aging into their renter household formation years, the labor market has been strong and supporting positive wage growth. And there's been a boost in housing demand overall.

Odeta Kushi - That's right, all that immigration boosting demand for all types of housing. And then there's the fact that in this country we've been underbuilding for over a decade.

Mark Fleming - We sure have. I was recently looking at the time series of housing starts, or groundbreaking on new homes. And, if we look even prior to my favorite decade of the '80s...

Odeta Kushi - All right, there it is. I figured we could get through a whole episode without a mention. 

Mark Fleming - I was running out of time getting a little nervous there. 

Odeta Kushi - Yeah, exactly.

Mark Fleming - Prior to my favorite decade, if we go all the way back into the early '70s, when the baby boomers were aging into their 20s, we were building more than 2 million homes a year. In the latest April housing starts report, it was 1.36 million annualized housing starts, so not even close when we were comparing to similar generational sizes.

Odeta Kushi - So the long-term housing shortage is a headwind to reaching our inflation goals. 

Mark Fleming - Yes, though, I still think there's more shelter inflation deceleration to come in the near term, but the crystal ball gets a little hazier the further out you look. But since shelter will be in short supply for years to come, there will be inflationary pressure on its price.

Odeta Kushi - Alright, so in summary, rent has an outsized and lagged influence on inflation. Weakness in the rental market has started to show up in shelter inflation and is poised to drag down overall inflation further in the near term. But there are signs that rent may be increasing, or at least not further decreasing, which again may be a future headwind to overall shelter inflation returning to normal.

Mark Fleming - Shelter inflation stagnation.

Odeta Kushi - You heard it here, folks. I think that's a good place to wrap. That's it for today's episode. Thank you for joining us on this episode of The REconomy Podcast. If you have an economics-related question you'd like us to feature in the future, you can email us at economics@firstam.com. And, as always, if you can't wait for the next episode, you can follow us on X. It's @OdetaKushi for me and @MFlemingEcon for Mark. Until next time.

Thank you for listening, and we hope you enjoyed this episode of The REconomy Podcast from First American. We're pleased to offer you even more economic content at firstam.com/economics. This episode is copyright 2024 by First American Financial Corporation. All rights reserved.

This transcript has been edited for clarity.