The Impact of Shelter Inflation

Understanding shelter inflation is crucial as households navigate inflationary pressures, given its significant presence in the Consumer Price Index (CPI). Shelter inflation is not just a minor detail in the CPI; it represents a substantial third of the overall index, underscoring the weight of housing costs in your overall cost of living. It represents the main obstacle to the Bank of Canada reaching its 2% inflation target.

Shelter costs most essential components include rented and owned accommodation. Calculated rents in the CPI are based on data collected from almost 8,000 rented units each month. CPI rent index price changes reflect changes in the rental costs of all renting Canadians, whether new, renewing, or in the middle of a lease.

The approach to measuring owned accommodation used in the Canadian CPI is based on various user cost approaches, focusing on specific payment changes on a set sample of housing representing the population at large. The index covers mortgage interest costs, property taxes, insurance premiums, maintenance and repairs, and other owned accommodation expenses, but it excludes capital gains and investment in dwellings.

With shelter inflation in Canada currently at 6.2% YoY, driven by a 7.9% YoY increase in rent and record-breaking mortgage interest costs, the Bank of Canada is caught in a policy impasse. Reducing the policy rate might inflame shelter inflation, albeit maintaining a high rate could squeeze the broader economy. This delicate balance is pivotal as the Bank of Canada (BoC) navigates the impact of its decisions on housing markets and inflation.

Inflationary pressures, which have seen consumer prices soar by 11.4% over the last 2 years, are not matched by wage growth, leaving many Canadians struggling. For the bottom 40% of income earners, net savings have dipped below pre-pandemic levels, and younger households are increasingly reliant on revolving credit debt to cover basic expenses, including shelter costs. The strain on Canadian households is unmistakable, with many Canadians expressing that rising prices hinder their ability to manage day-to-day expenses.

The BoC’s exclusion of volatile items, such as mortgage interest costs, from its core inflation index is now under scrutiny. With the current inflation metrics proving insufficient for guiding monetary policy, there's a pressing need to reassess the framework to reflect the structural challenges of housing better and address the inflationary pressures more accurately. At a staggering 6.2% YoY, Canada's shelter inflation rate is the highest on record. This surge is mainly attributed to escalating mortgage interest costs and rising rents. Contrast this with the US, where rent inflation has reached its peak and is starting to trend down as more new housing comes to market. If Canadian inflation were calculated using the same weights as the Fed's preferred metric, the figure would be a modest 2.1% YoY. A recent paper by James Orlando, Senior Economist at TD, highlights this more favourable inflation position than the BoC’s preferred metrics.

The divergence is partly due to Canada's housing supply struggling to keep pace with a recent uptick in immigration, which has not been the case in the US. The rapid population growth in Canada, fuelled by immigration, exacerbates the pressure on shelter prices. Most newcomers opt for rental housing initially, which amplifies demand and, consequently, the cost of renting. And those few wealthier immigrants who can afford to purchase housing only add to the same housing demand.

The BoC uses these preferred metrics to proxy inflation pressures related to oversupply or demand (or underlying inflation pressures). As some components of the CPI basket experience significant and often transitory price movements unrelated to underlying inflation trends, the BoC uses this basket of core inflation indicators to “see through” transitory changes in overall CPI inflation.

CPIX inflation was the central measure of core inflation for BoC from 2001 to 2016. CPIX inflation is a price index that excludes 8 of the most volatile CPI components and the impact of indirect tax changes on the other components. The 8 components not included in the index used to construct CPIX are fruits, vegetables, gasoline, fuel oil, natural gas, mortgage interest, intercity transportation and tobacco products.

High and untamed shelter inflation profoundly affects Canadians' financial well-being and the broader national economy. Despite the Bank of Canada's tightening of the policy rate to cool the economy, the low vacancy rate and robust demand for housing continue to fuel shelter price inflation. The complex relationship between asking rents and shelter inflation adds to the uncertainty, especially when considering future market shocks that could further complicate the inflationary landscape.

The persistent rise in shelter costs, particularly mortgage interest costs, which have soared by 27.4% as of January 2024, complicates the Bank of Canada's efforts to rein in inflation to the 2% target. The central bank faces the problem of managing inflationary pressures without destabilising the housing market. A challenge echoed in the current shelter inflation rate of 6.2% and TD's forecast that shelter inflation will average around 6% throughout 2024, regardless of the BoC's route, unless it decides to “look through transitory changes" as the CPIX did before 2017.

The BoC has resorted to monetary policy tightening in response to these pressures. However, the impact of early and quick rate cuts on the housing sector's inflation is expected to be minimal. Structural issues, such as the housing supply crunch and rapid population growth, fuel shelter inflation and necessitate a long-term approach beyond immediate rate adjustments. Governor Tiff Macklem has highlighted the need for government intervention to enhance home construction, acknowledging that monetary policy alone is insufficient to address housing inflation. Proposed government policies to stimulate construction include tax cuts on new rental units, increased funding for builders, and measures to reduce rental housing demand, such as capping the number of international students.

Increased volatility is an expected repercussion, as inflation and interest rate fluctuations make it challenging for buyers and sellers to predict future costs and values. This unpredictability can lead to rapid changes in the market, with prices potentially swinging significantly in short periods. Historically, inflation has driven home prices up at a rate surpassing general inflation, making homes less affordable. With the current trend of high mortgage interest costs, this pattern will likely persist, making it harder for many to enter the housing market. Due to the time, it takes for leases to be renewed or properties to be re-tenanted, the lag effect means that current market dynamics may not be reflected in shelter costs for up to a year. This delay can cause discrepancies between actual market conditions and perceived inflation in housing. The aggregate MLS HPI composite benchmark continued to grow even throughout the BoC’s rate-tightening cycle, illustrating the lack of housing supply. This surge is driven by a classic supply-and-demand imbalance, exacerbated by zoning restrictions and bureaucratic delays in approvals, which have not kept pace with the growing need for housing. The result is a supply shortage that fuels inflationary pressures on shelter costs. Meanwhile, a robust economy, exemplified by Canada's 5.8% unemployment rate in December 2023, bolsters consumer confidence and purchasing power, leading to increased demand for housing. This demand and a strong economy can escalate shelter prices, further inflating the housing market.

The Bank of Canada's policy rate stood at 5% in January 2024, a move aimed at tempering demand by making mortgages more expensive. However, this strategy has a nuanced impact: if demand remains resilient, the higher mortgage costs can paradoxically lead to even higher shelter costs. This delicate relationship between monetary policy and housing affordability underscores central banks' challenges in using interest rates to control shelter inflation.

Adjustments in government policies, such as zoning laws and building codes, could directly impact the housing supply. While these measures are essential for managing growth and ensuring sustainability, they should be followed through by policymakers to have their intended effects on shelter inflation. A holistic approach is necessary to navigate these challenges —one that involves coordinated efforts across monetary policy adjustments, legislative reforms, and the integration of timely housing market data. Will the Government of Canada remember its promises to Canadians years ago enshrined in its National Housing Strategy?

Navigating the housing market requires understanding these long-term implications, particularly how they relate to inflation in Canada and the broader economic landscape. When planning your next move in the housing market, remember that you’ll need to consider the timing of interest rate changes and their impact on mortgage affordability.?

You’ll have to consider your needs and be aware of the structural supply and demand issues that may affect market stability and, thus, the timeline for your mortgage strategy. If you want to finance a home, avoid risk on your downpayment by keeping it liquid in a high-interest savings account while earning some interest. Seek out lenders, such as nesto, with competitive rates to lock in your mortgage well before 120 days of your planned purchase, renewal, or refinance.