Shelter Component of CPI Offers Clues About Inflation

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Samuel Lau, I’m a portfolio manager at DoubleLine Capital.

Today, I’ll be discussing one of the big debates that market participants are struggling with, and that’s whether the recent inflationary trends we’ve had, whether or not they’re transitory or if they’re going to be persistent. This debate comes as the U.S. has recently seen its fifth consecutive year-over-year CPI print in excess of 5%. You can compare that 5% level to the 20-year average of really around 2% year over year. It’s been quite a bit of a pickup since the pandemic, but this fifth consecutive print, it hardly strikes me as transitory. And, perhaps even the Fed is starting to take notice as Jerome Powell changed his tone at his most recent post FOMC press conference, where he did note that factors such as supply chain disruptions, which impact the cost of goods, may be present longer than he had previously thought. One area that I continued to look at, to get some information, is the shelter component within the CPI basket for clues as really, it is the largest part of the headline CPI basket, it comprises roughly one third of the total basket there. And with that, we can also get a sense of where shelter inflation is going based on existing economic data. So, shelter in itself in the last print was up over 3% year over year. And more importantly, that rate has been steadily increasing since the depths of the pandemic-led recession. This shelter component is primarily made up of two categories. The first category is rent of primary residence or simply put it’s, how much do you pay if you’re a renter? And then the second component of shelter is known as owner’s equivalent rent. And that’s, essentially, a proxy of how much a homeowner would pay to rent the house that they currently own.

So it’s computed rent based on home ownership. So the shelter component is important in determining future inflation. Number one, because of its heavy weight in the CPI basket, but also because we can get a pretty good sense of where it’s headed. And that’s because historically, we’ve seen a strong relationship between shelter within CPI in the path of home price appreciation on the lag basis of around 12 to 18 months. That’s another way of saying that home price appreciation has been a pretty good predictor of future shelter inflation. And we know with certainty that home prices have already increased significantly since the beginning of the pandemic. And in fact, U.S. home prices are one of the few, if not only economic measures that never dipped negative during the course of the pandemic in 2020. A large contributor to that positive growth that we’ve seen in housing over this period of time is the lack of available units for sale.

The number of existing homes available for sale continued to decline throughout 2020 until it hit its lowest point on record in January 2021, at just over one million homes on the market today. So there’s been a dearth of supply relative to the amount of demand. So today when we look at it for the most recent data point through September, it’s up by about 300,000 units. So it’s just shy of 1.3 million units total available for sale. So it’s a little bit higher, but we’re still well near historical low inventory here in the U.S. So on top of that, you had the backdrop of bull mortgage rates that had come about based on accommodative monetary policy. So the cost of buying a home is somewhat low if you need to finance it. You also have factors like the work from home or hybrid environment, which has really opened up new possibilities of working from a new home in an entirely different city. The last 18 months or so have been on fire for the housing market.

Now with that said the one home price appreciation index is the S&P/Case-Shiller U.S. home price index. And that’s seen double digit year-over-year growth each month since December of last year. That most recent print was just shy of 20% year over year. And that makes it the highest year-over-year growth for that index on record. One of the things that we’ve looked at recently as well, and it was nice to see the confirmation on some of the work that we’ve been doing on our own is that researchers at the Dallas Fed, the Dallas Federal Reserve, to be more specific, have done some work around this need lag between shelter inflation and home price appreciation very recently. And based on this massive run up in home prices, those researchers at the Dallas Fed forecasted that shelter inflation will really begin to accelerate at some point beginning in 2022, and then ultimately reach a 7-8% year over year increase in both the rent and owner’s equivalent rent components by the time we reach December 2023.

Other items that could be driving up costs are rising input costs due to the higher commodity prices that we’ve seen across the commodity complex from the industrial metals to energy based products. Now that we’re heading into the winter season, they’ll become more important as we need to heat our homes, especially in the Northern states here in U.S., as well as in Canada. We’ve also seen it in food prices as well. And don’t forget we had the complexity of the supply chain issues that we’ve all read about in the past few months, the shipping delays, the lack of inventory. But based on these aforementioned reasons, I think that these elevated levels of inflation will likely be with us at least through year-end of 2022.