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We\u2019ve been hearing a lot about the risk of inflation lately. With government money flooding into the market and the economic recovery in high gear, we\u2019ve already seen some price jumps. The Federal Reserve has tried to calm fears by telling us that prices will settle back down, but rent prices are probably not among them, and higher rents, or what\u2019s known as shelter inflation, is a big part of the Consumer Price Index.

A recent Business Insider blog makes a case for rent growth as a catalyst for inflation -- that rents are starting to go up after a decline during the pandemic, and are not likely to \u201csettle back down.\u201d (1) The blog cites Morgan Stanley economists who say that rent prices are \u201cflashing signs of more persistent inflationary pressures\u201d and Goldman Sachs economists who say \u201cspecial factors that suppressed inflation during the pandemic\u201d have eased up. They feel that as other prices rise and pull back because of the reopening, that rents will continue to accelerate and will likely bring permanent inflation above 2%.

The central bank expects to see inflation rise above 2%, but not forever. The Fed likes that 2% mark, but is willing to let it run above 2% because it had run below 2% for such a long time. If inflation runs past the Fed\u2019s sweet spot and stays there for too long, we may see some changes in the Fed\u2019s strategy, such as short-term interest rate hikes. But what economists are all trying to predict is exactly where inflation will go from here. What I found interesting about the current situation is the role that higher rents would play in this scenario, and that shelter inflation may not be an accurate measurement.

Primer on Shelter Inflation

To understand this kind of impact, it\u2019s important to understand what policymakers are looking at. In this case, it\u2019s shelter inflation which tracks housing costs based on rent levels, and it\u2019s a major part of the CPI basket. Home prices don\u2019t figure into this calculation however. It\u2019s based on rent that tenants are paying, which is based on real numbers, and the \u201cimplicit rent\u201d that owner occupants would pay if they were paying rent on their homes, which is hypothetical.

The Labor Department collects this data from its Consumer Expenditure Survey. One of the questions posed to homeowners is what their home would rent for, in their opinion. The answer is called the \u201cowner\u2019s equivalent rent\u201d and it\u2019s up to the owner to provide that information. A recent Bloomberg opinion piece shows why this could spell trouble for calculating real inflation, because homeowners don\u2019t adjust as quickly as the market does to pricing pressures. (2)

Owners' Equivalent Rent

According to that blog, the owners\u2019 equivalent rent increased 2% this last April compared to a year earlier, while the National Association of Realtors reported a 16.2% increase in year-over-year home prices during the first quarter of this year. Bloomberg\u2019s author, Brian Chappatta, says: \u201cThis kind of wide discrepancy, unseen since the mid-2000s housing bubble, could have significant consequences for reported inflation statistics and monetary policy in the world\u2019s largest economy.\u201d

Goldman economists are expecting shelter inflation to push overall inflation permanently higher. As reported by Business Insider, they expect shelter prices to increase 3.8% year-over-year by the end of next year, and rise above 4% in 2023. And they don\u2019t expect it will be temporary. This isn\u2019t a direct correlation to higher home prices, but economists say that home price growth does eventually impact shelter inflation. It just takes a while.

Data Discrepancy

Chappatta said in his Bloomberg piece that the owners\u2019 equivalent rent \u201cunderstates the price appreciation in the housing market relative to the S&P CoreLogic Case-Shiller U.S. National Home Price Index. He says the owners\u2019 equivalent rent has gone up 31.5% over the past decade while home prices have risen more than 73%. That\u2019s a big difference.

He said that he doesn\u2019t believe this kind of measure is completely bogus, but that it doesn\u2019t do a good job as an economic indicator, mostly because homeowners aren\u2019t well-enough informed to provide market-based rent hypotheticals. It doesn\u2019t help that the pandemic is also skewing the current set of data points.

Rent Hypothetical Needs Scrutiny

Chappatta says there will always be questions concerning inflation but he says: \u201cThe Labor Department\u2019s rent hypothetical should receive extra scrutiny.\u201d And that\u2019s especially important right now, as the nation navigates an economic recovery unlike any other in our history.

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Thanks for listening.

Links:

1 - https://www.businessinsider.com/inflation-outlook-shelter-rent-prices-price-growth-permanent-economist-forecasts-2021-5

2 - https://www.bloomberg.com/opinion/articles/2021-05-13/april-cpi-housing-may-be-inflation-s-hidden-danger