The San Francisco Fed has published a letter titled “Will Rising Rents Push Up Future Inflation?” by Kevin J. Lansing, Luiz E. Oliveira, and Adam Hale Shapiro. Please, find below our review, comments, and possible implications for the Fed Board staff.
To keep in mind
The large increases in two leading indicators of future rent inflation—current asking rent inflation and current house price inflation—point to upside risks to rents inflation which could reach around 7% (YoY) in 2023 (from 3.8% in January 2022). The potential extra contributions to PCE inflation are estimated to be about 0.5pp for both 2022 and 2023. Nevertheless, the acceleration in rents can be partially offset by a deceleration of lodging away from home. Therefore, the total addition to PCE inflation in 2022-2023 from “shelter” is expected to be about 40bps in each year.
What the paper does
Research has shown that movements in current house prices can help forecast future rent inflation (Brescia 2021, Zhou and Dolmas 2021). For this reason, the authors use monthly data on asking rents and house prices from 15 MSAs to predict the path of future CPI rent inflation over the subsequent 24 months. The data cover the period from January 2014 to December 2021. The model considers how an individual MSA’s change in CPI rent inflation over various future horizons relates to the most recent 12-month percentage changes in Zillow asking rents and Zillow house prices for the same MSA, controlling for MSA-specific factors.
Results
According to the authors’ results, an increase in current asking rents or current house prices pushes up the CPI rent index for as long as 24 months into the future. Given the currently elevated levels of (Zillow) asking rent and house price inflation, the model predicts that CPI rent inflation will increase by about 3.4pp for both 2022 and 2023, relative to its historical average rate of 3.7%. Applied to CPI inflation, the author’ results imply an additional increase of 1.1pp for both 2022 and 2023 (from the current level). Applied to PCE inflation, the authors’ results imply an additional increase of 0.5pp for both 2022 and 2023.
How the authors’ results compare to existing literature
The results of the authors complement and reinforce the evidence of some papers released in recent months. As a reference, we report below the trajectory of rent inflation from Dolmas and Zou (August 2021) and Wilcox (December 2021). While Dolmas and Zou (2021) and Wilcox (2021) use different methodologies, they reach similar conclusions: rent inflation is expected to reach about 7 percent (YoY). According to Dolmas and Zou (2021) the peak is expected in late 2023, while according to Wilcox (2021) the peak should be reached in the second half of 2022.
Dolmas and Zou (2021)
Wilcox (2021)
Comment and possible offsetting factors
The authors’ results (as well as previous analyses) refer to “rents of primary residence” but can be taken as a good proxy for OER, given the high correlation between the two. Nevertheless, CPI “shelter” includes a third item (“lodging away from home”) which can potentially offset part of the expected acceleration in rents. The charts below show the relevant metrics (YoY, 2YoY2 a.r., 3m3m a.r., and 6m6m a.r.) of CPI “primary residence” and CPI “lodging away from home”. While the YoY of CPI “primary residence” is at the pre-pandemic level (and expected to increase significantly as mentioned above), lodging away from home expanded 20.5% in the 12 months ending in January 2022 (with the 6m6m a.r. at -2.3%). Going forward the deceleration of “lodging away from home” can offset about 2 tenths of the “primary residence” acceleration in CPI space and 1 tenth in PCE space. Therefore, the total expected acceleration in PCE space is about 40bps.
Rents of primary residency
Lodging away from home
Implications for the Fed Board staff
The San Francisco Fed letter confirms previous analyses. As such, in our view its results will not be surprising to the Fed staff. Nevertheless, in our view the Fed staff continues to forecast core PCE price inflation in the medium-term according to calibrated the fundamentals (underlying inflation, slack, etc..), and not following a bottom-up approach. As such, the Fed staff will continue to be exposed to the risk of being behind the curve. In our view, the Fed staff should have deviated from the 2022 fundamentals months ago. Unfortunately, in our view they are now putting their reputation at risk. Hopefully, core inflation will moderate soon but at the moment there is little in the data that suggests that.