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Article Highlights
- Housing is major share of household budgets and remains elevated in inflation indexes, pushing up overall inflation
- Price growth of new leases has fallen back to pre-pandemic levels, but broader shelter costs lag new leases
- Our model suggests almost two years for new lease prices to pass through to contract rents and CPI
Inflation has fallen significantly since it peaked in mid-2022 but has yet to fully return to its 2 percent target. One of the forces keeping inflation stubbornly high is that shelter inflation has continued to run well above pre-pandemic levels. In this note, we use data on market rents (rents that are reset in a given month) and shelter inflation (which includes both market rents and fixed rents) to assess how long shelter inflation is likely to remain elevated given current conditions in rental markets.
Our estimated model suggests that market rents filter through to shelter inflation very slowly, implying that housing’s contribution to inflation could remain elevated for the rest of 2024 and into 2025. Using data through June, our model projects shelter inflation at 4.8 percent year over year in December 2024 and remaining above pre-pandemic levels through the end of 2025. For reference, shelter inflation is currently 5.2 percent, well above its 3.3 percent average annual growth from 2016 to 2019.1
Shelter inflation is keeping core inflation elevated
Figure 1 shows the core consumer price index (CPI) rate and splits it into contributions from shelter, goods, and services excluding shelter. Elevated shelter inflation is clearly driving the persistence in CPI inflation.
Through June, core CPI inflation was 3.3 percent; shelter alone accounted for 2.3 percentage points, or more than two-thirds, of core inflation. If shelter inflation were at its pre-pandemic levels, core CPI inflation would be 2.4 percent, nearly a percentage point lower.
The contribution of shelter inflation is also keeping the Fed’s preferred core personal consumption expenditures (PCE) measure of inflation elevated, but to a smaller extent. The two inflation series measure changes in shelter prices in the same way, but the PCE places a smaller weight on shelter (18 percent versus 45 percent), so the contribution of shelter to the total is smaller.2 At its pre-pandemic levels, core PCE would be 0.4 percentage points lower (2.2 percent instead of 2.6 percent).
Market rents have normalized, but the CPI measure is still catching up
The CPI seeks to measure the prices consumers are paying for goods and services they are consuming. For renters, the price of shelter is the current monthly rent they are paying. We call this the “contract rent.” As rents are typically fixed for the term of a lease, the contract rent can differ from the rent the house or apartment would fetch if it were newly listed for rent today, which we call the “market rent.”
Market and contract shelter inflation
It is natural to think that when market rents rise, contract rents will follow with a delay as leases expire and get reset at higher levels. This dynamic is indeed what we saw in 2021–2022. Market rents, as measured by the Zillow Observed Rent Index, started to rise rapidly, and over time CPI shelter inflation followed suit (Figure 2).
The normalization of market rent growth in 2023 led many to expect that growth in contract rents and CPI shelter inflation would soon return to more normal levels by mid-2024. Market rent growth peaked in early 2022 and returned to pre-pandemic levels in August of 2023. CPI shelter inflation peaked 12 months after market rents. This 12-month lag led to some expectation that CPI shelter would return to pre-pandemic levels by the third quarter of 2024.
However, the firm shelter inflation readings at the start of 2024 have led to a rethinking of this forecast. In the 10 months from August 2023 to June 2024, shelter inflation has been 4.4 percent. Thus, shelter inflation would need to be sharply negative in the next two months to get back to its pre-pandemic rate of 3.3 percent.
When will lower market rents translate into lower shelter inflation?
These observations led us to ask how quickly and how closely measures of market rents translate into CPI shelter inflation. To answer that question, we estimate a state-space model that uses several data series as measures of market rents to extract a common tendency in market rents. The estimation calculates the rate at which leases reset to the market rent and takes account of the fact that the housing survey used by the Bureau of Labor Statistics to measure CPI shelter inflation only samples units twice a year.3
Our estimation finds that it takes nearly two years for contract rents to catch up with market rents. This delay reflects the typical term of a lease, but also the possibility that a landlord does not raise the rent immediately all the way to market rate when the lease renews. Because of this estimated lag and the recent dynamics of market rents, our forecast suggests that shelter inflation could stay above 5 percent through the remainder of the year. Moreover, CPI shelter inflation would only approach pre-pandemic levels by the end of 2025, instead of the second half of 2024 (Figure 3).
Shelter inflation and the lags of monetary policy transmission
Milton Friedman famously observed that monetary policy works with long and variable lags. The behavior of shelter inflation provides a window into one source of these lags. Even if monetary policy were to affect market rents instantaneously, the rents measured in the CPI would only gradually reflect these market conditions. In the current context, market rent growth normalized more than a year ago. Yet we are still waiting for the effects to fully materialize in standard measures of inflation.
Endnotes
1 All inflation rates are expressed in 12-month percent changes unless otherwise noted.
2 The core PCE price index is preferred to core CPI given its broader scope and that it better reflects consumer substitution away from goods that become more expensive to goods that become cheaper.
3 We use the Zillow Observed Rent Index and the Bureau of Labor Statistics New Tenant Rent Index as measures of market rents, and the CPI shelter index as a measure of contract rents. The BLS measures shelter inflation by taking the sixth root of six-month changes in rents on individual units. We follow this procedure by treating the CPI shelter index as the sixth root of the six-month change in contract rents.
