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Are the Inflation Kernels Starting to Pop?
On Friday, I wrote about the outlook for housing inflation, which is a big part of the overall (and especially core) CPI. If you missed that piece, you can find it here. As a quick update: today, the FHFA House Price Index was reported +1.5% for August, versus expectations for +0.7%, and the S&P CoreLogic neé Case-Shiller 20-City Home Price Index was reported at +5.18% y/y versus expectations for +4.20%. So, as I noted in that piece – the signs for home prices remain very supportive, and that suggests that rents are unlikely to continue to decelerate for very long.
I focused first on housing because that is the largest and most-ponderous category of the Consumer Price Index. Today I want to turn more broadly and look at everything else, collectively. Because I think there are some reasons to think that not just housing, but the inflation process itself, is starting to look more buoyant.
Although we are somewhat conditioned to think of inflation as a smooth process, with all prices sort of rising/accelerating as one, that’s not how inflation happens. Thinking about the process this way – as a rising tide that gradually increases the price of everything – means that we have a predisposition to look at each individual price change and see if we can identify the “reason” for the price change; if we can find one, then that must not be inflation but rather a one-off event. Used cars CPI is a great case study: over the last few months, the CPI for Used Cars and Trucks has spiked and is now rising at about 10% y/y (see chart, source BLS).
Is that inflation? Well, to some observers it is just a one-off effect. For example, an argument by Twitter user @thestalwart in response to this spike in prices was:
Now, this ‘assumes a can opener’ because there hasn’t yet been a sudden and widespread move to the suburbs; moreover, to the extent that commuting is way down shouldn’t that mean a bigger supply of used autos? What about the car rental fleet shrinkage with business and leisure travel way down? Rental is a large source of used cars. Nonetheless, it is surely true that in each market where inflation (or disinflation) happens, you can point to movements of supply and demand in nominal space…that’s just Econ 101. In other words, there is always an explanation to be had beyond “everyone just raised prices because there’s inflation.” And inflation doesn’t happen in a uniform way. I like to say that it is like microwave popcorn: not all kernels pop at the same time, but eventually the bag is full. For each kernel, you can look at local conditions that determined exactly when that kernel will pop (“this one was moister than others, so that’s why it popped”). But the overall cause is “heat.”
So waiting until that time when you have prices rising for no apparent reason is just waiting for Godot. There’s always an excuse.
Recently, there has been evidence that the “heat” is rising. Anecdotally, the Wall Street Journal had a story a few days ago entitled “Why You Might Have Trouble Getting the Refrigerator, Can of Paint or Car You Want,” with the subtitle “Factories rush to keep up as Americans spend on their houses and vehicles.” Again, the story is that there are various bottlenecks on the supply side but the simple explanation is that there’s a lot of people trying to buy and not enough goods to sell. That’s actually the classic definition of inflation: “too much money chasing too few goods.”
Anecdotes are fun, but let’s try to look at this a little more analytically. Enduring Investments has developed an inflation diffusion index, derived from BLS data, which gives a different look at the breadth of inflation. It doesn’t take a weighted average, like Core CPI, and it doesn’t take the midpoint of the consumption basket like Median CPI. Instead, it looks at the number of categories that are seeing prices increasing faster or slower than 2%, weighted equally in their category and with each of the eight major categories getting 1/8th of the overall weight. As a price index, this is absurd – why would you weight Owner’s Equivalent Rent only slightly more than Full Service Meals and Snacks when consumers spend vastly more on shelter? But as an indicator of breadth, it makes some sense: there are, after all, a lot more different sorts of goods that fall under the category “Full Service Meals and Snacks,” and we make purchase decisions in that category more frequently than we make decisions on rents as well. So, in terms of the proportion of decisions made that are seeing higher price acceleration, arguably the index for meals and snacks should be higher. (There is nothing magic here, just an attempt to get a better view of inflation breadth. There are other ways to look at the same thing).
Over time, as the chart shows, the Enduring Investments Inflation Diffusion Index tends to move with median inflation. But interestingly, in the post-Global Financial Crisis period these two have diverged, with the diffusion index in negative territory more normally associated historically with crisis or recession periods. This helps explain why there has been little investor interest in buying inflation protection even though the Median CPI has been rising fairly steadily for seven years! But that may be changing: the EIIDI has been in the single digits negative for three of the past four months, and the 12-month average is the highest it has been since the end of 2013.
For a while, the story of inflation in the US has been that shelter inflation was strong, some other services were seeing some inflation, but the vast majority of goods were seeing stable to declining prices. This is changing. Shelter has been softening – although as I noted last week I don’t think that will continue – but we are seeing pressures percolate more widely. The corns are starting to pop more frequently. Keep an eye on that bag!
The Outlook for Housing Inflation from Here, Oct 2020
In the last couple of CPI reports, two trends have started to become apparent. One is that inflation is broadening, in that more categories are seeing accelerating inflation. The second is that shelter, the largest and slowest-moving subcategory, has been decelerating.
Is there an inflationary process going on, then? Or are we in a disinflationary or even deflationary period? The answer to this question depends a little bit on what we think the inflation process is, and a little bit on figuring out what is really happening in housing.
I originally wrote this as one long piece, but decided rather to split it into two. So today I’m going to talk about why I think the shelter component of CPI is probably not about to enter into an inflation-dampening slide; on Monday or Tuesday I’ll discuss the inflation process itself and the broadening of inflation.
I have long said that if you’re going to predict core deflation, you’d better have a reason to expect deflation in housing. And if you’re going to predict accelerating core inflation, you’d better have a reason to expect acceleration in housing. Shelter is the 800-pound elephant in CPI; it moves slowly and ponderously and if it sits in one place, you’re not going to move the broad index very far. And the story for the better part of two decades in inflation is largely this: shelter inflation has been consistent and in the 2%-4% range; everything else in core has been fairly consistent but lower.[1]
The exception, of course, was in 2009-10, when the housing implosion dragged down rents in a short but deep dip. But if you’ll look at the following chart, which splits core into Shelter and ex-Shelter components, you’ll see that nothing else really looked like deflation was in the offing. Indeed, if you take out shelter, core inflation barely slowed in the aftermath of the Global Financial Crisis (Keynesians, take note).
To get a real inflationary outcome, then, we’ll need two things. One of these is that shelter needs to not decline, but rather accelerate. And the other is that non-shelter inflation needs to pick up. None of this needs to happen tomorrow, but it needs to happen. So, when Keynesians see Shelter declining markedly, they become gleeful because it sure doesn’t look like the enormous deficit spending and explosive money growth is doing anything to cause inflation.
Not so fast! Let’s take a deeper look first. The three main components of Shelter are (a) Owner’s Equivalent Rent, which is ~73% of Shelter; (b) Rent of Primary Residence – that is, apartment renters – which is ~24% of Shelter; and (c) Lodging Away from Home, which is about 2.8% of Shelter. (The difference is rounding and a little bit of “Tenants’ and household insurance.”) The chart below shows the y/y changes in these three pieces, unweighted.
Clearly, Lodging Away from Home provides a ton of volatility, and that massive decline – and not much of a bounce – has deducted about a third of a percent from the year/year growth rate of the broad Shelter CPI index. Lodging Away from Home is clearly and directly impacted by a lack of travel, so to get a better idea of the general shelter trends let’s strip that away. The two main categories, then:
Not surprisingly, Primary Rents and OER track each other very well. This makes some people very angry. Some mathematically-challenged inflation-conspiracy “alternative stats” sites claim that the Bureau of Labor Statistics changed to the rental-equivalence method of computing shelter costs to “hide” the real inflation, which they say is really 5-6% per year higher than what is reported. This is obvious nonsense, and I hate to always have to debunk it because it’s so easy to do. The reason that the US uses rental-equivalence is that you can think of a house as providing two things to the owner: an investment, and a place to live. It’s important to separate these two functions of a house, and so the BLS reasons that the “place to live” part is in competition with other ways you can get a place to live without the “investment” part: in other words, a rental. This gets confusing at times when home values are rising faster or slower than rents. This happens because although the “owner’s equivalent rent” part of a home is in competition with “rent of primary residence” – and so these two series move together as the chart above shows – the investment value of the house has no analog if you’re a renter. So when home prices and rents diverge, it is best to think of the divergence being caused by the investment portion.
Incidentally, you can understand this equivalence by reflecting on the fact that these two situations have equivalent financial outcomes: (1) live in your owned home and (2) rent your owned home to someone and use that income to rent someone else’s owned home. In both cases you are living in a house, and get investment returns related to home prices. But in the second one you’re clearly paying rent, and you also own a home that earns you the change in home prices plus a stream of rental payments, even though the two rental streams in this case (the one you’re paying, and the one you’re receiving from your tenant) happen to cancel. That’s essentially what is happening, then, in (1) and it’s the reason the BLS looks at housing in that way.
So, how much difference does it make over time to use rents, rather than home prices, to measure the cost of “shelter services”? The chart below shows the median price of an existing home, compared with OER. Note that prior to the bubble era, rents and prices moved pretty close in lock-step…through the late 1990s, there was no difference – certainly not 5-6% per year! And even with the wild swings induced by the ‘environment of abundant liquidity’, median home prices have risen ~4.2% per year since 1982, compared with ~3.2% for OER. One whole percent per year, which means the dastardly BLS has understated Shelter costs by 0.7% per year, and overall CPI by roughly 0.2% per year! Oh, and as lately as 2013 the difference was exactly zero percent per year. This seems like a conspiracy theory in search of a conspiracy.
Back to the story we came here to discuss. Why are rents decelerating, and is there reason to think that will continue?
In some parts of the country, notably in dense metropolitan areas where taxes and violence are rising, rents have not only slowed their rise but are actually in decline as renters can easily pick up and rent elsewhere. But elsewhere, rents are showing normal trends. The following picture, sourced from https://www.apartmentlist.com/research/national-rent-data, illustrates this phenomenon. New York, as President Trump recently noted, really is becoming a ghost town and rents are falling briskly in L.A., San Francisco, Boston, Washington, Minneapolis, Seattle, and Chicago and more mildly in Portland, Denver, Chicago, Houston, Dallas, and Philly. But they’re rising in lots of other places.
Also, rents in the CPI aren’t ‘asking rents.’ They are based on a survey of landlords, who report the rents they have actually received in the latest month plus any amounts they expect to receive in arrears. So if someone has paid rent to the landlord, that rent is included…but someone who is behind on the rent isn’t treated a zero. Instead, the landlord reports what amount of rent he/she expects to eventually receive. At times like the one we are currently living in, this can matter. While the government grants early in the year actually kept incomes surprisingly robust despite the lock-downs, those streams of money are drying up and with it, the potentially ability of some renters to make the rent. If landlords give a grace period to the renter, that doesn’t show up as a rent decline. But if the renter sneaks out the back window like George Thorogood,[2] it will. Nevertheless, at the moment the number of renters making full or partial payments is not too far below par, according to the NMHC Rent Tracker. However, if after a “blue wave” election the Congress declared a “rental holiday,” there would be a massive decline in the BLS rental figures. I give that a very low probability of happening, but it’s a risk to be aware of.
Overall, then, rents are softening mostly in the big cities and this is being reflected in Owners’ Equivalent Rent as well (for a good if wonky explanation of how the BLS measures Owners’ Equivalent Rent, see this publication on the BLS website). But how confident are we that this will continue? Notably, exactly the opposite thing is happening in home prices. Just this week, the National Association of Realtors reported that the median price paid in Existing Home Sales rose 15.4% over last year – the fastest rise since 2005.
That’s remarkable, and I must say unexpected. Some will say that this is a sign of a wave of people moving to the suburbs; maybe that’s true. But while 10-20% per year home price appreciation going forward seems unlikely, it is also unlikely that home prices are going to fall very much since the inventory of homes available for sale is near the lowest level in many, many years; historically, low inventories lead home price appreciation by about 12 months.
Although rents are decelerating, at least looking backwards, I find it very hard to believe that can be sustained. Apartment rental and home ownership are, after all, substitutes to some degree, and while they sometimes diverge for a time rents almost always eventually follow prices. In the Global Financial Crisis, for example, the drop and eventual recovery in home prices led OER by about 18 months, which is why it was pretty easy at the time to know that October 2010 was going to be the low in core CPI, plus or minus a month or two.
Now, lagging home prices is one way to get rents, and as you can see it doesn’t really suggest that a collapse in OER is imminent. But at Enduring Investments we also use an income-based model since one might reasonably suspect that when people’s incomes decline they are less likely to be willing and able to pay high primary rents, and over time if the amount that people spend on shelter is reasonably stable then the rise in nominal incomes is likely to parallel the rise in nominal rents. And although it doesn’t fit the contours of rents as well as one based on home prices, the implication of that model is very interesting, thanks to the big jump in incomes due to government transfer payments.
If you look at home buyer traffic, and what’s happening to home prices, it doesn’t seem a big stretch to suggest that at least some of that is resulting from the income replacement schemes that have left some people actually better off than before the crisis. The income model actually suggests we could see a decent acceleration in rents in the latter half of 2021.
When we put our various models together, we get a more stable picture that suggests the recent dip in rents is overdone and not likely to be the start of a significant slide lower (again, assuming no rental holiday!); in fact, the 800-pound gorilla might begin moving north soon.
That’s all for today on housing. On Monday or Tuesday, I’ll have a much shorter piece discussing the broadening of price pressures, and how that factors into the outlook. Thanks for reading. Be sure to stop by Enduring Investments if you would like to start a dialogue on this topic and how we can help you manage inflation risks.
[1] And for the better part of this last decade, I’ve been writing periodic updates about housing inflation, which you can find on my blog in the “Housing” category at https://inflationguy.blog/category/economy/housing/. What’s amazing is how many times I say “recently, there has been some alarm about OER” or “some people have been saying housing inflation is about to head lower.” Seems a recurring theme!
[2] “So I go in my room, pack up my things and I go/ I slip on out the back door, down the streets I go/She a-howlin’ about the front rent/She’ll be lucky to get any back rent/She ain’t gonna get none of it.” – One Bourbon, One Scotch, One Beer as sung by George Thorogood & The Destroyers.
Summary of My Post-CPI Tweets (October 2020)
Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy. Or, sign up for email updates to my occasional articles here. Investors, issuers and risk managers with interests in this area be sure to stop by Enduring Investments!
- Another COVID-era #CPI report coming up this morning. After two big upside surprises versus economic forecasts, the forecasts this month are …lower.
- Last month, economists were looking for a “strong” 0.2%, something 0.21%-0.24%, and got close to 0.39%. That was a month after the 0.62% print.
- This month, the forecasts are for 0.2% on core, but a 1.7% y/y. We can look at the year-ago number and figure out that to keep 1.7% from rounding to 1.8%, core can’t be 0.21% or higher. So economists are clearly expecting a “soft” 0.2% on core.
- …something closer to what was normal before COVID. I’m still not sure we get normal.
- The “COVID categories” (hotels, airfares, etc) still haven’t fully recovered, and despite the recent bump in used car CPI it’s still well behind private surveys which continue to accelerate. Never know if that will happen THIS month but still looks like some room there.
- We’re also starting to see reports of pressure in medical care, which so far hasn’t made it into the CPI in a significant way. And the weakness in the dollar since spring will eventually help apparel a little.
- Now, we still have some near-term downside risk from housing, but more and more any weakness there (and it has been a touch soft, which makes the upside surprises even more surprising) looks transitory.
- We’ve all seen the reports of plummeting rents. But those are in cities, and it turns out that a lot of renters don’t live in cities. Outside of cities, rents don’t appear to be under pressure.
- If renters are being more delinquent such that landlords expect to collect less, this would pressure the measurement of rent inflation – but the NMHC tracker says the share paying rent through Oct 6 is the same level as in 2019. https://nmhc.org/research-insight/nmhc-rent-payment-tracker/
- Meanwhile, there are signs from the housing market that there is actually upside risk ahead – I really meant to write a column this month on the housing indicators but just didn’t get to it.
- For example, one important longer-term driver of rents and OER and home prices is incomes, and incomes are very strong right now thanks to federal income replacement. Will they be this strong in 4 months? Probably not, but presently these incomes are driving housing outcomes.
- All that said, OER and primary rents have been a little weak recently and my gut is bracing for something even softer. But there’s no analysis there, just a concern. Even a little housing softness could produce a ‘soft’ 0.2%.
- Rents are really the only ‘normal’ thing that can drag this number lower. But this is the COVID era, and nothing is normal, so there can always be weird one-offs, in both directions. With M2 rising at 24% per year, these are more likely to be on the positive side.
- All of these one-offs on the high side are what inflation looks like, after all. Inflation is like microwave popcorn. The kernels go off one at a time, and each has a micro “explanation.” But eventually the bag is full, and the MACRO explanation was “heat.”
- Outside of rents, inflation is broadening, quickening, and deepening. It surprises me that it has happened so early…I thought it would take until 2021…but if we get a third surprise today then we’ll have to start thinking it’s here already.
- Do remember of course that the #Fed doesn’t care one bit about inflation. But if you do, and have interests in how to hedge/invest in the inflationary period approaching, visit https://enduringinvestments.com and drop me a line. Good luck today.
- Well, soft 0.2% it is. +0.19% on core CPI.
- y/y on core at 1.73%, so basically unchanged from last month.
- OK, so used cars was +6.7% m/m, even more than last month’s jump. Core goods, partly as a result, went from 0.4% y/y to 1.0% y/y. But core services plunged from 2.2% to 1.9%. And where?
- Yep, OER was only +0.06% m/m, which pushed the y/y down to 2.49% from 2.69%. Primary rents +0.12% m/m, so y/y fell to 2.72% from 2.95%. My gut was right – there was (near-term) downward pressure there.
- Lodging away from home, which had been recovering, slipped back some last month -0.38% m/m. I guess the end of the summer vacation season means it’s all business travelers, and not many of those.
- Apparel fell, -0.45% m/m, despite weaker dollar. But the real surprise might be medical care, which FELL despite lots of evidence that prices are increasing. Need some charts here.
- Physicians’ services -0.29% m/m. Really? Talk to any doctors who are doing price cuts recently?
- Amazing that we were able to get an 0.2% even with housing so soft (and again, the bigger indicators on housing are pointing higher). Core inflation ex-housing rose to 1.50% y/y. Disinflationary pulse from COVID basically over already.
- College tuition and fees fell to 0.71% y/y from 1.31%. This is clearly a quality effect that isn’t being captured by a quality adjustment, and the BLS knows it but can’t figure an easy fix for what is a 1-year problem. Remote-learning isn’t worth the same as in-person.
- Tuition had been under pressure anyway because endowment returns had been fantastic for a while, but this dip is because colleges can’t charge the same for e-college.
- Motor vehicle insurance continues to be a drag on services inflation. People are just not driving as much, and insurance companies are rebating premiums. Biggest 1m declines this month were Infants/Toddlers Apparel (-36% annualized) and Motor Vehicle Insurance (-35%).
- The surprising part of that might be the fact that Motor Vehicle Insurance has a 1.7% weight in the CPI. That seems like a lot, but we only notice it once a year when we get the renewal.
- Biggest core gainers this month were Motor Vehicle Fees (+10% annualized 1m change) – governments gotta make it somewhere! – Public transportation, jewelry, car & truck rental, used cars, leased cars, miscellaneous personal goods.
- Health insurance is also finally coming off the boil.
- m/m decline in health insurance (NSA) is largest in a long long time.
- …I guess that decline in health insurance is because people aren’t going to the doctor for minor maladies as much? But of course remember health insurance in the CPI is a residual, not a direct measurement of premiums.
- So here is OER versus our ensemble model. This month I REALLY have to do a column on housing, because the right side of this graph has been revising HIGHER while the spot numbers have been surprising lower. There are big reasons to think rents are NOT about to decline hard.
- Forgot to mention one of the covid categories: airfares were -2.0% m/m after +1.2% last month.
- The jump in used car CPI was, as I noted up top, not really surprising. But it looks like we’ve squeezed most of that lemon (no car pun intended) unless the private surveys keep accelerating.
- So, despite an as-expected number, bond breakevens have plunged 3.5bps since the print. Investors are conditioned to not ever take inflation breakevens much above 2% or swaps above 2.5%, no matter the outlook. That’s a gonna hurt.
- Sorry for the break – calculations. Here’s a fun one. It’s our measure of perceived inflation minus core inflation (consider it “inflation angst”), versus the subsequent return to gold.
- Four pieces: Food & Energy, trendless.
- Core goods, impressive. Although a lot of that is used cars. Pharmaceuticals pretty soft, import prices not worrisome yet. Apparel soft. So this might be best we can expect from this piece, about 20% of the CPI.
- Core services less rent of shelter. Settled back a bit, although as noted I’m skeptical that medical care costs are about to go into retreat…
- And finally, rent of shelter. A lot of this deceleration is hotels, but as noted earlier rents are definitely soft and that’s the big story this month.
- So, to sum up: housing inflation looks soft, but forward-looking indicators there are pretty solid as long as incomes don’t collapse again (they’ll decelerate and maybe even decline, just need them to not collapse). Outside of housing, there’s broadening of price pressures.
- Yes, core goods exaggerates where those pressures are at the moment, but they are definitely there. And with money supply rolling 24% y/y, it’s going to persist. The question for Keynesians is: where is the deflation, man? We never even got close!
- Thanks for tuning in. Have a great day.
Later this month, I definitely need to talk more about housing. Since housing is always the biggest and slowest piece of consumption, any argument about meaningful disinflation or inflation must include a discussion about housing. Right now, when there isn’t an overall inflationary or disinflationary trend, the slow waves in rents are really the main driver of core, and everything else is noise around that trend. When we get into a more-extended inflationary or disinflationary trend, then housing will likely follow the overall underlying trend. This hasn’t happened, though, in decades – which is why most models of rental inflation now tend to be built on a nominal frame rather than in real terms. But I digress.
Most of the main rebound of the “Covid” categories seems to be over. While those categories – apparel, airfares, lodging away from home, food away from home – still sport prices below their pre-Covid levels, it may be that they just don’t come all the way back any time soon. Ergo, the potential for upside surprises from those categories, going forward, is lessened. Similarly, I’m not sure we have a lot more upside to used car prices, as CPI has mostly caught up to the private surveys (of course, used car prices might still go higher, but at least the CPI has caught up to what we already knew). So, again, we come back to rents. Will rents continue to decelerate? The headlines suggest an implosion of the rental property market. But in the meantime, the median price of existing home sales was recently reported as +11.4% y/y, the biggest jump since 2013 (and back then, we were still rebounding from the financial crisis). Home prices and rents cannot diverge for long; they are substitutes.
And with the money supply spiraling higher at an all-time record pace, it is hard to imagine that hard assets like homes will see prices decline, or even level off. Think about it this way: if you have an exchange rate between apples and bananas, say 1:1, and suddenly there is a bumper crop of bananas, then you’d expect the price of bananas fall relative to apples. Right now there is a bumper crop of money, and so it’s reasonable to expect the price of money to fall relative to the price of real assets like houses (each dollar buys fewer houses). Of course, what that means is that the price of houses, in dollar terms, ought to keep rising.
If that happens, then the recent softening of rents is likely to be temporary. That’s the next phase of the inflation puzzle – looking for the rebound in rents.
