Rental Rates Are Falling - That's Good News for Inflation Data

Today’s FHFA Home Price index showed a second consecutive monthly decline in home prices despite an 11.9% increase over last year. It’s important to distinguish between the yearly change and the monthly change because while the double digit increase still looks daunting, the recent trend is positive news for the Fed as it seeks to bring inflation under control, and in particular, the Shelter component of the Consumer Price Index (CPI)

We've been following the housing component of CPI since last December but it is not based on home prices – it is based on rental rates – some actual and some hypothetical. CPI shelter is made up of two components, what's called Owners Equivalent Rent (OER), which makes up 24% of the overall CPI number, and rent of primary residence, which makes up 7% of overall CPI. The difference between those two is that OER is based on a survey question asked of consumers who own their primary residence. It’s a simple question – “If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?” On the other hand, Rent of Primary Residence is based on what consumers actually paid in rent when they do not own their primary residence.

It's interesting to note that this outsized component of CPI is based on a hypothetical question instead of what a consumer actually paid and that, to make the responses even more debatable, is based on an asset that has sentimental value to the consumer. There could potentially be consumers that believe their house could rent for more than they could actually rent it based on recent home price increases and specifically if their neighbors recently rented their house at the peak of the market. As prices come down, from a psychological perspective, consumers may not lower their hypothetical rent rates immediately. So it’s very likely that surveys would imply that rental rate increases are faster than rental rate declines. However, this is a completely personal hypothetical observation.

CPI shelter is also a component of what's called Sticky CPI, which captures a subset of all of the products and services in the CPI whose prices change infrequently. Think about a lease on an apartment with a term of one year. Those leases have to come due or have to be renewed in order for those new rental rates to show an actual decline or a slower rate of increase.

Today’s report of a decline in home prices from last month is important despite not being part of the CPI because rental rates lag home price changes by about 12-18 months. This relationship has implications for CPI Shelter going forward now that there have been two consecutive months of home price declines, which followed a month that was essentially flat. Prior to that, there was at least a 1% monthly increase in the FHFA index for 9 consecutive months.

Using a 15 month lag of rental rates to home prices, we can assume that the latest CPI shelter reading can be tied to the 1.9% month over month increase in in home prices from last June. As the chart below indicates, that month was the fastest monthly increase in 2021, after which, monthly increases slowed for two months before accelerating again.

If the relationship holds, we should start seeing slower rental rates over the next two months and even though home prices started accelerating again towards the end of last year, the current environment may not allow landlords to raise rents as much. In fact, rental rates may already be reversing.

The key dates to watch out for in CPI Shelter data, however, are the next two months – coinciding with home price deceleration from last summer - and then again September and October 2023 CPI data, which coincides with the 15 month lag of June’s home price increase of just 0.1% - the first month since the pandemic with less than a 1% monthly increase. By that time, the Fed should realize that the sticky inflationary pressures that have been so persistent are starting to wane – if they haven’t realized that sooner.