Dom’s Quick Take: Shelter Inflation Could Nix Fed Easing

Summary

• A new Boston Fed note highlights upside risks to 2024 shelter inflation, based on a positive gap between market rents and CPI shelter costs.
• While the note expects the gap to close, recent data and anecdotal evidence show market rent inflation is accelerating again, which could see higher shelter inflation.
• Higher shelter inflation would make it difficult for the Fed to stick to its easing bias.

Market Implications

• I continue to expect no cut in 2024 against 1.8 cuts currently priced in.

The Fed on Shelter Inflation: It’s Complicated…

The 12 June FOMC was more hawkish than the market expected, especially following the lower-than-expected May CPI print. The resiliency of shelter inflation in the May CPI, 40bp vs 38bp in April, was no doubt a key driver.

During the presser, Powell explained that, while market rent inflation had slowed, the translation to lower shelter inflation was taking longer than the Fed initially expected (shelter inflation is an average of inflation in market rents paid by households that moved and of rents paid by those that did not move). He stated, ‘Nonetheless, as long as market rents are going up at relatively low levels, and they still are, you know, this is just going to happen. It just is going to happen more slowly than we thought.’

A new research note from the Boston Fed (17 June) provides the analytical underpinning of the slower passthrough of market rents to shelter costs, and of Powell’s confidence that shelter disinflation will eventually resume.

The note finds that when the gap between market rents and shelter inflation is positive, it closes through shelter catching up to market rent inflation. The gap was 6ppt larger in March 2024 than in December 2019.

The note estimates that, relative to a zero gap, the current gap will add 1.6 ppt to CPI shelter inflation, and 0.74 ppt and 0.29 ppt to core CPI and core PCE inflation, respectively, from June 2024 to June 2025. It also expects shelter inflation to remain high through the end of 2024 and slow in 2025.

Market Rents Inflation Accelerating Again

The Boston Fed note concludes that ‘the market–shelter gap is likely to pose a significant, but diminishing, challenge to the Fed’s ability to achieve its 2 percent inflation target over the next year.’ The ‘diminishing’ challenge assumes that market rent inflation will not accelerate again.

But recent data show that market rent inflation is troughing (Chart 1). This creates a risk that the market-shelter gap could widen again and pull up shelter inflation. A recent WSJ article cites real estate professionals warnings that rents have been rising again.

Prior to the pandemic, goods price deflation compensated for above-target shelter inflation. This time, though, shelter inflation is so far above the Fed target that no plausible goods price deflation could make up for it (Chart 2). That is, shelter disinflation must fall for the Fed to feel confident about disinflation.

The Boston Fed note suggests this will not happen in 2024. Longer term, recent rent market data and anecdotal evidence suggest shelter costs inflation could have more upside than downside risks.

Market Consequences

I continue to expect no cut in 2024 against the markets currently pricing 1.8.

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Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.

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(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)