Insights & Advice


The Fed’s key inflation gauge

Inflation is worrying investors. Every new data point seems to be heightening their anxiety.  Oil and other commodities are raging higher. The rate of wage increases is also climbing, but the most important variable the Fed is watching is about to move higher.

Housing and/or home ownership is one of the most important components of the U.S. economy. However, housing prices per se are not included in the Consumer Price Index (CPI). Instead, the CPI measures the cost of shelter, which is broken down between actual rents paid and the Owners’ Equivalent Rent or OER.

OER is the amount of rent that would need to be paid in order to substitute a currently owned house as a rental property. It measures (in an indirect way) the value of the present price increases in the real estate market, including your home.

One could call it the “shelter” component of the Consumer Price Index, which is published by the Bureau of Labor Statistics. The OER represents about one third of the CPI basket and it is a number the Fed watches carefully.

You may wonder why rent is included in the CPI, but not food and energy. The Fed considers price fluctuations in food and energy as transitory. If, for example, OPEC decides to raise oil production next month, the price of oil would probably decline. That, in turn, would likely impact how much consumers will pay at the gas pump. Rents, on the other hand, are stickier and tend to last longer.

It is obvious to most readers that housing costs have skyrocketed during the last two years. Since the start of the pandemic, inflation-adjusted home prices have increased 11.8% annualized. To put that in perspective, real house prices have been rising 100 times faster than they did from 1955 to 1998.

But there has been no commensurate increase in the OER, until recently. That is because there is usually a lag time between increased housing prices and rent increases (by roughly five quarters). That lag time is now up and, right on schedule, we are beginning to see OER impact the inflation rate in both the CPI and the PPI (Producer Price Index). In September 2021, the shelter index rose by 0.4%, accounting for nearly one third of the increase in prices across all goods and services in the CPI.

That is the largest increase in 20 years! OER rose by 0.4%, while rents of primary residences rose by 0.5%. Those were the biggest one-month increases since the early 2000s. Economists blame the results on rapid housing price gains, more aggressive landlord pricing, low inventory, and faster wage growth.

For the Fed, this is bad news. As the headline number of the Fed’s inflation gauges, the CPI and the Producer Price Index (PPI), continue to climb higher, the pressure to raise interest rates sooner rather than later is building. The idea that broad-based inflation pressures will continue to rise thanks to supply chain issues and aided and abetted by wage growth has the financial markets nervous.  They also know that some of the long-lasting economic forces that have kept inflation low for decades have been turned on their heads. China, for example, is exporting inflation right now, after functioning as a massive deflationary force for the last thirty years.

Consumer expectations for inflation are continuing to surge, rising to 5.3% over the next year, and 4.2% over the next three years. Both are the highest in the history of data going back eight years, according to the New York Fed.

As it stands, about half of the Fed’s policy makers are expecting to start raising interest rates next year and think borrowing costs should increase to at least 1% by the end of 2023. That timetable may have to be pulled forward if the present trends continue. Watching the OER may give us an early warning of what the Fed will do next.







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