Shelter from the storm

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  By Guest Blogger Doug Rowat

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Eventually, every market crisis passes into the rearview.

The GFC, the European sovereign debt crisis (remember the PIIGS?), the Brexit crisis, the Covid crisis and, most recently, the inflation crisis.

But we’re not through the inflation crisis say the naysayers. True. We haven’t yet reached the Fed’s ideal 2% inflation target and shelter costs continue to create a persistently stubborn and major headwind for US headline CPI. The February CPI number released just this week supports this: all-items inflation clocked in at 3.2% y-o-y, but shelter costs rose 5.7% y-o-y.

But let’s examine these problematic shelter costs. What’s been driving this CPI component and how big a problem has it been for inflation overall? And could we now, finally, be seeing light at the end of the shelter-inflation tunnel?

US shelter costs make up roughly a third of all the US Labor Bureau’s CPI components. In terms of shelter’s relative importance, it carries almost 3x the value of the food category and more than 5x the value of the energy category. In short, shelter costs matter. A lot.

To put their impact in perspective, if shelter costs hadn’t remained so stubbornly high, the US economy would have been at the Fed’s 2% inflation target nine months ago. The chart below shows CPI without shelter costs (blue line) as well as shelter inflation in isolation (red line). The chart not only illustrates shelter inflation’s stickiness but also how much improved the overall US inflation picture would be without it:

A thorn in the side: CPI, shelter (red line) vs CPI, less shelter (blue line)

Source: FRED. Shaded areas – recession

So why did shelter inflation soar and why has it been so sticky?

Primarily, housing affordability. Coming out of the global pandemic, US home prices took off. This was the result of a variety of factors, including a lockdown-induced desire to have more space combined with a housing supply shortage, but the net result was that renting became comparatively more affordable. More rental demand ultimately meant higher rents. Owners’ equivalent rent, which refers to the hypothetical rent homeowners would pay if they weren’t homeowners—and also a major CPI component—skyrocketed as well. But it was all fueled by the jump in home prices coming out of the 2020 pandemic:

S&P CoreLogic Case-Schiller US National Home Price Index: a post-pandemic jump

Source: FRED. Shaded areas = recession

So why might shelter inflation moderate now?

First, it has been moderating, albeit slowly. Shelter inflation was, for a time, steadily in the 8% y-o-y range but, as noted above, has now come down to 5.7% y-o-y as of the latest February 2024 reading. Housing price growth has moderated as well over the past 18 months and more rental supply is coming online, resulting is an uptick in rental vacancy rates (from 5.8% to 6.6% over the past year). Rental costs also tend to be a lagging data point because, as FRED points out, “they change only when leases renew or a tenant moves, so it may take time for those prices to reflect market conditions.” In other words, it may take time for softer rents to be reflected in the overall inflation data.

But make no mistake, US rent growth is softening.

According to Zumper, which provides an extensive database of available US rental units, rent growth has been trending steadily lower over the past year. In fact, y-o-y rent growth for 1-bedroom units recently turned negative:

1-bedroom (red line) & 2-bedroom (blue line) US rent growth

Source:Zumper

The bottom line is that one of the most persistent inflation roadblocks could soon be far less of a problem.

And then yet another crisis will pass into the rearview. Pity the naysayers.

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Investment Advisor, Private Client Group, Raymond James Ltd.