This Week’s Developments in the US Economy

Higher for Longer: How Shelter Readings Are Driving Warmer Inflation

With the next Fed meeting nearly a week away, recent robust economic readings and warmer-than-expected inflation print are likely to keep the Fed on hold in the short term with rate cuts anticipated mid-year. While higher rates continue to have meaningful implications for real assets, the higher, sticky inflation readings are being driven in large part by shelter components. Specifically, multifamily contract rents and OER, a proxy measure for homeownership. Both indicators operate with a significant lag, which begs the question, when should we expect inflation to fall?

The short answer from a shelter component’s perspective is likely not soon. This is because OER (“Owner’s Equivalent of Rent of Residences”) contributed approximately half of the latest core CPI print, and the OER is a proxy measure for the housing market that is indirectly related to the general stability of housing prices as well as single-family rent levels. In addition, changes made in January to the OER methodology increased the weight of detached single-family homes. This has contributed to inflation running hotter than anticipated, with January posting one of the widest gaps between OER and rent inflation since 1995. OER holds significant weight in the US inflation indices, representing 34% and 13% of core CPI and PCE, respectively, thus having a meaningful impact on overall inflation. To understand better why shelter inflation continues to run warm and influence Fed policy, we unpack below both the recent headline readings as well as the drivers of OER.

February CPI Readings Suggest the Potential for Sticky Inflation

In February, headline and core CPI slightly exceeded consensus expectations at 3.2% and 3.8%, respectively. Headline CPI saw a slight uptick when compared to readings in January, with shelter and energy (gasoline) components driving over 60% of the increase in month-over-month inflation. The persistence of higher print in both headline and core CPI highlights continued stickiness, with the non-tangible OER inflation component playing a significant role in this trend.

What Is Owners’ Equivalent Rent? Is It Phantom Inflation?

OER is an estimate of the rental value of owner-occupied housing. Unlike other direct measures, such as the change in the cost of car insurance over time or in the price of milk from one month to another, OER is not based on actual transactions—at least, not directly. In its monthly Consumer Expenditure Survey, the BLS asks homeowners how much they think their home would rent for monthly, unfurnished and without utilities. Rather than looking at the value of the property or the monthly mortgage expense, OER is the estimated monthly rent of a housing unit based on the rent of comparable renter-occupied units in the same geographic area.

Driving OER today in part is a combination of the increased weighting on detached single-family housing, single-family rent growth running higher than that of multifamily, and consumers’ perception of home price appreciation. While not intended as a direct measure of housing prices, OER appears to be influenced by them. Based on our internal analysis, the current OER inflation has the strongest correlation with existing median home price growth around a 1.5-to-2-year lag when looking at data from the past two decades. Assuming this trend analysis holds, we expect OER to remain high for some time as home prices have seen stability throughout the Fed’s current rate hike cycle.

Going forward, we anticipate that OER will exert upward pressure on CPI, in part driven by single-family rent growth outpacing multifamily, as suggested by the Zillow Observed Rent Index (see accompanying visual). As of January, single-family year-over-year rent growth stood at 4.8%, while multifamily rent posted a 2.8% growth. Further, with observed year-over-year growth in median existing home prices since July 2023, the combined effects are likely to result in higher shelter component readings that run counter to what we are observing in markets today.

Although the revised weights in the OER could lead to slightly higher CPI readings going forward, we maintain our outlook for the Federal Reserve to implement rate cuts mid-year. This is partly because PCE, the measure favored by the Fed, is closer to the 2% target. Next week’s Fed meetings will provide some insight in addition to the inclusion of the quarterly Summary of Economic Projections and the Fed members’ Dot Plot.