What a turbulent 7 days …
… these have been. Last Tuesday, at his Semiannual Monetary Policy Report to Congress, Fed chair Powell sent market interest rate soaring, by stating that “inflationary pressures are running higher than expected at the time of our previous Federal Open Market Committee (FOMC) meeting“. 2Y Treasury yields even hit 5%, a high not seen since 2007. This increase was apparently the straw that broke the camel’s back – at least for Silicon Valley Bank, which was closed by the Federal Deposit Insurance Corp last Friday. This bank failure, the largest in the US since the global financial crisis, and the subsequent closure of another bank (Signature Bank) spooked financial markets. Stocks sold off and market interest rates tumbled. In a joint statement, the Treasury, the Fed and the FDIC tried to calm nerves and prevent further bank-runs by ensuring that depositors of the closed banks will have full access to their money. While this seemed to have worked for now, the question remains, just how many more rate hikes the market can take.
There can be no doubt that in other (read: normal) times, the Fed would have not even thought about raising interest rates in a situation like this; in fact, they might have even considered a Greenspan-put-like rate cut to ease financial conditions and to shore up markets. But these times are – well – different. The Fed is, after all, still on a mission to bring stubbornly high inflation rates down. Let’s not forget that Chair Powell’s hawkish comments are only a few days old. All said, I guess the Fed will next week go ahead with another 25bp hike – even though they shouldn’t.
Only shelter prevents inflation and core inflation from coming down massively
On the surface, today’s CPI report confirmed Chair Powell’s concerns about too-high inflation rates: The headline consumer price index rose 0.4% in February (6.0% yoy), while the CPI ex food and energy even increased 0.5% (5.5% yoy). Those short-term dynamics would indeed imply that inflation rates remain high for even longer than thought. That conclusion, however, would be too simplistic in my view. To get a better idea of what is going on, one has to look at the details below the surface. And once you do that, the story of a broad-based inflation problem falls apart.
Rather, it is only one single component that prevents headline and core inflation rates in the US from coming down massively. And that is ‘shelter’. The first chart reveals that consumer prices excluding shelter have only risen by an annualized 2.2% over the past six months, much less than the 12% seen in the middle of last year, and not much higher than its long-term average. The same holds true for the CPI ex food, energy and shelter. In contrast to this significant moderation in prices pressures, rents and the infamous owners’ equivalent rent have continued to surge (for more on how the CPI accounts for the cost of housing, see this Brookings article by Wessel and Campbell 2022). As a result, the shelter index in the CPI rose 8.1% over the past twelve months and even an annualized 9.1% over the past six months. Both are the largest increases in forty years!
As the shelter index makes up more than a third (34%) of the CPI basked and even 43% of the core CPI basket, these increases have massive impacts on the current inflation rates. In February, shelter costs contributed no less than 2.8pp to the headline inflation rate and an even more stunning 3.5pp to the core inflation rate!
But as the housing market is already suffering from high rates, rents will follow soon
The good news is that this shelter inflation will soon reach its peak. After all, higher interest rates have already left a significant mark on the US housing sector, as existing home sales plunged 37% over the past twelve months, while housing starts are down 21%. House prices have also begun to moderate. The widely-followed S&P/Case Shiller national home price index peaked in June and has declined 4.4% in the second half of last year. Its yoy-increase moderated from 20.8% to 5.8% by year-end; and the trend continues to be down.
An empirical analysis by Dallas Fed researchers Zhou and Dolmas (2021) suggests that house prices are leading the CPI shelter component by 16 to 18 months. This is also corroborated by the second chart, which depicts the Case Shiller index with a 16M lead over the CPI shelter index. If historical correlation holds (and yes, that is of course an important assumption), shelter inflation will peak in the middle of this year, before falling back towards 5% or so by year-end.
Inflation could hit 3% to 3-1/2 by year-end
In order to get a feeling what this might all mean for this year’s inflation outlook, we are adding the pieces together.
- If the CPI ex shelter continues to increase at its current rate (2% over the past 6M) and shelter inflation eases to 5%, headline inflation will decelerate to 3.1% by year-end.
- If the CPI ex food, energy and shelter continues to increase at its current rate (2.2% over the past 6M) and shelter inflation eases to 5%, core inflation will decelerate to 3.4% by year-end.
There are of course huge uncertainties around this outlook. But I think it is important to get the story straight. The US is not suffering from broad-based inflation pressures anymore, but from a historic surge in shelter costs. Apart from that, price pressures have moderated perceptibly as the impacts from various supply shocks and the fiscal stimulus have petered out. With the housing market already suffering from high interest rates, it is only a question of time before the slowdown will also be reflected in the CPI shelter index. Importantly, this outlook does not factor in any further rate hike. Instead, it is the previous policy tightening that works its way through the system and affects the economy with a lag. Accordingly, the Fed does not have to break the market with more rate hikes but can afford to focus on financial stability.
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