Is Inflation Here to Stay?

• Growth in the consumer price index (CPI) has moderated, and some investors seem hopeful that inflation worries are in the rearview mirror.
• One-third of the CPI is drawn from shelter costs, a series that is hard-wired to grow above trend in the near term.
• Are investors underwriting a 10%+ decline in apartment rents, or will shelter costs continue to burden the CPI?

We saw a good deal of optimism in the market around the recent cooling in the growth of the U.S. consumer price index (CPI). Word on the street is that real estate lenders and investors at the CREFC conference in Miami earlier this month expressed a hope that, with cooling growth in the CPI, hikes in the federal-funds rate will ease. If correct, such an easing could lead to lower mortgage rates. I wonder if that hope has a chance of being realized or if real estate costs themselves will continue to push up inflation.

For more than a year now I have been talking with clients about the challenges of price changes in the real estate market feeding back into the CPI. I wrote about the topic last September, and in the interim a number of tools have been introduced to take a deeper dive into the topic. The Federal Reserve Bank of Cleveland introduced an index tracking the growth in rents that new tenants pay for an apartment versus the embedded rent across all tenants.¹ That measure of embedded rents is effectively what drives the shelter component of the CPI.

Gimme shelter?

Shelter costs were weighted to represent 32.9% of the CPI in December of 2022, but as shown in the exhibit below, represented 38.2% of the growth in the index from a year earlier. Earlier in 2022, energy costs were punching well above their weight and represented much more growth than the weighting would suggest. The cooling in energy-price growth has helped overall inflation cool, but what does the data tell us about shelter costs?

That embedded rental-growth figure is, effectively, a three-year trailing average of the spot-market rents that new tenants pay for apartments. Given the nearly 12% year-over-year growth in spot-market rents in midyear 2022 as measured by the Cleveland Fed, rent growth in 2023 would need to decelerate sharply to bring growth in shelter costs back to a normal pace.

From 2013 to 2019, that normal pace was 2.9% per year based on the Cleveland Fed’s All Tenant Repeat Rent (ATRR) Index, which closely aligns with the CPI. Using simple math, one can calculate how much spot-market rents would need to decelerate in 2023 to bring shelter costs back to that longer-term average by year-end. Given that the average growth from 2021 through the third quarter of 2022 was a 7.6% annual pace, spot-market rent growth would need to fall in a linear fashion to a 10.4% annual pace of decline by the fourth quarter of 2023 to get back to that normal pace. A more protracted slowdown to get back to average by the end of 2024 would need to see rent growth decline by 0.4% by year-end 2023 and stay flat through 2024.

Sources: Cleveland Fed, Bureau of Labor Statistics, author’s calculations

Thinking through the likelihood of potential outcomes

To determine whether these outcomes might come to pass, I could recreate one of the formal models I used to build, which linked housing demand to rent growth.² But simple thought experiments might deliver just as much insight. Old surveys of the spot-market rents by valuation professionals never fell by more than a 5% annual pace looking all the way back to the 1980s. Granted, rent growth never got up to the double-digit pace seen in 2022 either, so in the transition from 2022 to 2023, we are dealing with an out-of-sample issue, and the predictability of the market relative to long-term trends may be limited.

Still, to get to a 10.4% annual pace of decline in apartment rents by year-end 2024, it seems some combination of a collapse in housing demand along with robust new construction would be needed to shock apartment vacancy rates enough. With job growth still at a healthy pace despite cutbacks by tech firms, can housing demand fall to this extent?

More pointed, is a collapse in housing demand something that all those lenders and investors at the CREFC event are underwriting in their analysis of investments and loans? These professionals are hoping that inflation, interest rates and mortgage rates will trend lower in the year; but if housing, roughly one third of the CPI, still has legs for above-average growth, is such optimism warranted? Perhaps they should conduct a thought experiment about whether only apartments may see ongoing growth, while all other components of the CPI fall.

¹Brian Adams, Lara Loewenstein, Hugh Montag, and Randal J. Verbrugge. 2022. “Disentangling Rent Index Differences: Data, Methods, and Scope. Federal Reserve Bank of Cleveland Working Paper No. 22-38.

²“Freddie Mac Report to the Federal Housing Finance Agency: Housing Finance Reform in the Multifamily Mortgage Market.” Barclays Capital, Morgan Stanley, CBRE Global Research and Consulting, Moody’s Analytics, and Freddie Mac, November 2012.

Further Reading

Real Estate Likely to Transition to Be a Source of Inflation

What Can We Learn from the July CPI?

2023 Trends to Watch in Real Assets

MSCI Perspectives: Real Estate Investors Brace for Bumpy 2023