by Zak Myers, CloudQuant quantitative Researcher
The Fed has been raising interest rates in an attempt to curb inflation. Why then, did we see such a large year-over-year (YoY) increase in Core CPI this month while Headline CPI had only a slight drop in the YoY increase from the previous month? To understand this, we need to look at the way the cost of shelter is calculated as an input to these indices. Shelter is calculated based on rent, as Owners’ Equivalent Rent (OER) is used for owner-occupied units and homes. OER is a measurement of how much it would cost to rent the home, calculated by looking at the rent of equivalent rental units in the area.
As can be seen in figure one, OER is fairly inelastic, and lagged, in relation to average home prices. Rent, on the other hand, has been steadily climbing since the start of 2021 as per the Zillow Observed Rent Index. The increased rent is now appearing in the CPI calculation, as enough time has passed to allow renters to renew their contracts at higher rates. The effect of pushing down house prices due to interest rate hikes has long lag times with the highest correlations at 18 and 16 months on rental rates and OER respectively (Zhou and Dolmas).
In this sense, the large jump in Core CPI this month may be a symptom of the Fed’s cure for inflation rather than the disease. With consumers hesitant to buy a home due to the higher mortgage rates (7-8.5% for most borrowers), the demand for rentals is increasing and driving up rental costs. In a similar sense, we’ve seen a decrease in job postings throughout the U.S. as companies begin to adjust to the rate hikes (LinkUp Job Market Data). It may seem like a negative development, but is also the symptom of the Fed’s prescription. To confirm this hypothesis, we look at Headline CPI excluding Shelter and see the rate of increase has been slowing since June, and our estimate for Core CPI Less Shelter shows a much more modest increase this month of only about +.1% from last month (Figure two). While inflation is still high, we’re now starting to get glimpses of rate hikes slowing the economy and sometimes confounding inflation measures that don’t capture the full story.
Figure 1: Comparison of the annual change of average home prices and OER over time. OER appears to be inelastic compared to the larger fluctuations in home prices. Data was pulled from the St. Louis Fed FRED dataset.
Figure 2: The year-over-year change by month for different indices. Core CPI Less Shelter is an estimate from CloudQuant based on the weights and factors of Core CPI. Data was pulled from the St. Louis Fed FRED dataset.