Inflation Other Than For Shelter Has Moderated – And Shelter is Special

The Bureau of Labor Statistics released its regular monthly report on the Consumer Price Index today, with data through April 2023.  Most news reports focused – understandably – on the twelve month change in the overall CPI as well as of the core CPI (the CPI excluding the food and energy components, as the prices of food and energy are volatile and go down as well as up).  But in looking through the figures, I came across an interesting aspect that I have not seen discussed.

Specifically, while the overall CPI index has been declining slowly (the 12-month rate ending in April was 4.9% overall – down from a peak of 8.9% in June 2022), this was mostly due to the shelter portion of the CPI.  If one excludes the shelter component of the CPI, the most recent 12-month rate was 3.4% (down from 10.6% in June 2022 – see the chart above).  Furthermore and of greater interest, the 6-month rates for the CPI excluding shelter have fluctuated between essentially zero and 2.0% since December 2022.  This has been not just a one month fluctuation:  The 6-month changes have been at annualized rates of 2.0% or less for five months now.  And the Fed’s target for inflation is 2%.

The shelter component of the CPI, in contrast, has been steadily going up (until recently) since early 2021.  It is special for a number of reasons.  One is that it is the single most important component of the CPI, with a 35% weight in the index.  In comparison, food accounts for 13% and all energy for 7%.  Second, and importantly, estimating price changes to enter into the CPI for shelter is difficult.  As explained in detail in this factsheet from the BLS, the cost of shelter that enters into the determination of a consumer price index is not (as many mistakenly assume) the cost of buying a home.  Buying a home is an investment.  Rather, what enters into the cost-of-living index is the rental equivalent cost of living there.  The BLS imputes this rental equivalent cost by gathering data on the rents in fact being charged in that geographic area, and then adjusts these to take into account differences in quality and in payments made for associated services (such as for utilities, where payments to utilities are accounted for in a different area of the CPI).

A third and very important aspect of rents (and hence the rental equivalent for owner-occupied homes) is that rents change only periodically – usually annually.  Hence when the BLS surveys what rents are being charged in some geographic zone, the rents they will record will include households whose rents have been constant for close to a year as well as some households whose rents had recently stepped up but which will now be constant for a year.  Suppose, for example, that due to pressure in the markets, rents in some area are all being raised by 12%.  This will then lead to actual changes in the rents being paid month by month as the rental contracts come up for renewal.  With the renewals more or less evenly spread over the course of a year, in the first month roughly one-twelfth of the households will see their rents rise by 12%, but the rents for the other households will remain unchanged.  Hence the overall rise in rents, as then recorded in the CPI (and reflected as well in the rental equivalent cost in owner-occupied homes) will be just 1% in the first month.  In the second month it will rise to 2% (i.e. two-twelfths of the households will be paying 12% more and ten-twelfths will still be paying the same as before), and so on until after 12 months – and only after 12 months – the increase in rents being paid by everyone in the area will be the full 12%.

Thus the shelter component of the CPI – reflecting what people are actually paying in rents (and hence also what rent is imputed to owner-occupied homes) – changes only slowly over time.  This is seen in the chart at the top of this post, and not only with the recent increases since 2021 but also in the far more steady rates seen in the years before when compared to changes in the CPI excluding shelter.  (And note that in the period of 2014 to 2020 the increases in the cost of shelter were around 3 to 4% a year, or well above the prices in the CPI excluding the shelter component:  Housing was becoming steadily more expensive compared to other items in the CPI.)

The cost of shelter then started to rise, as noted above, from early 2021.  And in terms of the 12-month rate, it has risen steadily until very recently, where it has leveled off for three months now at about 8.1%.  But there are signs that it will soon start to come down (i.e. not increase as fast).  Not only has it leveled off, but the 6-month rate (annualized) has come down from 9.0% as of January to 8.1% now.  The 3-month rate is now 7.2%, the 2-month rate is 6.0%, and the 1-month rate is 5.2% (all annualized).

This suggests that the pace of inflation in shelter costs will be declining. There will certainly be bumps up and down, and given how rents are determined, the process will be a slow one.  It built up over a two-year period (from early 2021 to early 2023) and might well take a similar period of time to come down.  There will also certainly be ups and downs in what will happen to other prices in the CPI, especially for food and energy.

But for several months now, what has been driving the CPI above the Fed target of 2% has solely been the cost of shelter.  With increases in the cost of shelter now moderating, while the non-shelter components of the CPI are already at the rates seen prior to 2020, what we are now seeing in the rates for the overall CPI basically reflect the time lags that result from long-term rental contracts.