The persistence of housing inflation at elevated levels in the U.S. economy has been a cause for concern, even as overall inflation has shown signs of cooling in recent times. Economists have pointed out that the slow decline in housing inflation is a key factor holding back the consumer price index from reaching the target set by policymakers. Housing, which accounts for a significant 36% share of the CPI index, plays a crucial role in shaping inflation readings, given that it is the largest expense for the average household. As Jessica Lautz, deputy chief economist at the National Association of Realtors, explains, shelter inflation, which is a measure of U.S. rental prices, exerts a significant influence on overall inflation indicators.
The sluggish pace of decline in shelter inflation has been somewhat unexpected, with the rate falling to 5.2% annually in June 2024 from a peak around 8% in early 2023. Despite the progress, the current level remains about 2 percentage points above the pre-pandemic baseline. The discrepancy between the shelter inflation index and the real-time rental market dynamics has raised eyebrows among economists. While the annual inflation rate for new rental contracts plummeted to 0.4% in the first quarter of the year, down from record highs of around 12% just two years earlier, the lag in the CPI data for shelter inflation has been notably slower.
One of the main reasons for the sluggish response of shelter inflation to changes in the rental market is the methodology used by the federal government to construct the housing inflation index. The government’s approach involves a delayed reflection of changes in shelter prices, leading to notable lags in the CPI data. Federal Reserve Chair Jerome Powell acknowledged the issue, highlighting that it might take several years for the shelter CPI readings to capture recent rental market trends accurately. The complexities arise from the fact that while renters’ expenses are easier to assess, homeowners’ costs are treated as investments rather than consumption goods, making it challenging to align them in the CPI basket.
The concept of owners’ equivalent rent (OER) plays a crucial role in bridging the gap between renters and homeowners in the CPI calculations. The BLS imputes a rental value to owned homes, considering the theoretical income that homeowners could generate by renting out their homes. This adjustment helps standardize the costs associated with homeownership and rental accommodation in the inflation index. While this approach has been in place since 1987 and is followed by many countries worldwide, the lag in reflecting changes in rental market dynamics in the CPI data persists due to the staggered panel sampling technique employed by the government.
Experts anticipate that shelter inflation will continue to moderate as it aligns with the evolving trends in the rental market. The gradual slowdown in rent growth is expected to persist as more rental units become available, balancing out the demand-supply dynamics that drove inflation during the pandemic. Factors such as increased construction of multifamily units and the easing of demand pressures are likely to contribute to a more subdued rental price environment. As the CPI data catches up to the recent rental market shifts, the shelter inflation index should reflect a more accurate representation of the housing costs experienced by Americans.
The lingering issue of housing inflation in the U.S. economy underscores the complexities involved in measuring and interpreting inflation indicators accurately. While the sluggish decline in shelter inflation poses challenges for policymakers and economists, the gradual convergence of CPI readings with real-time rental market dynamics offers hope for a more balanced and reflective inflation assessment in the future.