Inflation has yet to be tamed, according to the US Consumer Price Index (CPI) report for January. While the news focuses on the headline inflation rate, central bankers are more concerned about core inflation – price growth less volatile price components such as food, shelter and energy – because it tends to be a better indicator of future headline inflation. Core inflation can be broken down into three components: core goods, housing services, and core non-housing services.
Core goods inflation, which looks at items such as clothing, appliances and vehicles, has been cooling as supply chain disruptions have eased. The shelter component in the US CPI includes both rental costs and the consumption value of owner-occupied housing, in addition to other forms of lodging such as hotels. Shelter makes up nearly a third of the basket for CPI inflation, and 40% of the basket of core CPI.
In 1983, the US Bureau of Labour Statistics switched from using home prices to using “rental equivalent” prices to gauge the cost of housing. The rationale being that homes are an investment, while rent represents consumption. The rental equivalent is intended to measure the implicit value of services that homeowners “consume” from their own home. Specifically, it is the price that homeowners expect their home (unfurnished and without utilities) can be rented month-to-month.
Lagging data distorting the true inflation rate
At a speech at the Brookings Institution on November 30, 2022 Fed Chairman Powell made the following comments about housing costs in inflation:
“Housing inflation tends to lag other prices around inflation turning points, however, because of the slow rate at which the stock of rental leases turns over. The market rate on new leases is a timelier indicator of where overall housing inflation will go over the next year or so. Measures of 12-month inflation in new leases rose to nearly 20 percent during the pandemic but have been falling sharply since about midyear .”
Housing costs and current rents have broadly been declining since June 2022, but have not registered in the CPI because of the lag in how the CPI measures these costs. A number of economists, including Jay Parsons, have been highlighting this issue as well as other problems with the index. As noted by the Bureau of Labour Statistics, this lag is estimated to be around 12 months.
The Fed is measuring service inflation that strips out housing and energy services to adjust for these issues in the shelter component to get a better measure of underlying trend in inflation.
January CPI report fuels rate hike worries
The US January CPI report came out mostly as expected with headline prices up 0.5% month-over-month or 6.4% on an annualized basis. This was largely due to an increase in energy costs (+8.7% year-over-year) as well as food (+10.1% year-over-year).
Core prices (inflation excluding food and energy) were up 0.4% month-over-month. On a yearly basis, this was a 5.6% increase, but down from September’s high of 6.6%. The shelter component was up 7.9% year-over-year and accounted for nearly 60% of the total increase in the core. However, the Federal Bank of Cleaveland’s Median CPI, which provides a better signal of the inflation trend, increased at 8.1% (annualized rate), while the Trimmed Mean CPI, which excludes CPI components with the most extreme monthly price changes, increased at 7% (annualized rate). This suggests that inflation is still broadly too high.
Looking at just core service inflation, excluding housing and energy services, this index was up 0.24% month-over-month, and the yearly rate eased to 6.1% from 6.4%. The 3-month annualized rate for this measure was 3.7%, which is down dramatically from the peak of 9.1% reach last June.
While the trend for inflation may have turned, the US still has an inflation problem. The economy and labour market are still operating above capacity, and for inflation to consistently be at the 2% target rate, the economy will need to move from a state of excess demand to a state of shortfall.
US inflation is slowly heading lower. However, core price inflation remains elevated and, combined with strong January payroll data, will keep the Fed biased towards raising rates. The dilemma for the Fed is how tight a monetary policy stance to take – and for how long – to achieve the desired rebalancing of the economy.
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