Housing costs—which are often a household’s primary expenditure—weigh heavily on consumers, leading to questions about how fast-rising rents and home prices contribute to inflation. The Consumer Price Index (CPI) measures changes in topline inflation by tracking everyday household expenditures on goods and services, but it does not necessarily capture the full scope of trends in the housing market.
There are many indices that track changes in home prices, using varying methodologies. Those most commonly used are repeat-sale indices because they control for the quality and newness of homes by measuring changes in the same house’s price over two sales. The S&P CoreLogic Case-Shiller Home Price Indices, CoreLogic Home Price Index, and the Federal Housing Finance Agency House Price Index are all examples. For rental housing, the Zillow’s Observed Rental Index is among the most cited. It similarly calculates price differences for the same rental unit over time before aggregating those differences.
Comparatively, the Consumer Price Index is a cost-of-living index, which measures the prices of a basket of hundreds of goods and services consumed by households, tracking these items’ price changes and assigning weighted averages based on their average share of total household expenditures. The CPI market basket does not include the cost of housing units because spending to purchase and improve housing is investment, not consumption. However, the Bureau of Labor Statistics (BLS) does use its survey of consumers to collect and calculate the cost of shelter, which is the service that housing units provide. This important distinction results in key differences between home price indices and the shelter component of CPI (“CPI: Shelter”), which includes both rental costs and the consumption value of owner-occupied housing and comprises almost a third of the CPI basket.
For rental housing, CPI is calculated using the price of rent for rental housing (“CPI: Rent”). For owner-occupied housing, CPI imputes the value to homeowners of “consuming” the shelter service that a home provides (known as “CPI: OER,” the owners’ equivalent rent of a primary residence), and which a homeowner forgoes by not renting the home to somebody else. OER is calculated using rental data and weighted by the price that homeowners think their home can be rented monthly, a calculation designed to reflect the value of a home more accurately as a shelter rather than investment.
As shown in Figure 1, CPI: Shelter is the sum of CPI: Rent and CPI: OER. CPI: OER comprises roughly three-fourths of the shelter index, so its behavior is a major driver of shelter inflation. CPI: Shelter is then factored into the overall Consumer Price Index.
It can be difficult for CPI to capture the rising cost of housing because the CPI is designed as a cost-of-living index that measures the prices of day-to-day household goods and services, not the value of household investment assets. The cost of housing is less volatile than other everyday goods in the CPI basket like groceries, gas, and clothing. Because leases and mortgages are typically fixed over long periods of time, households face increased housing costs infrequently or when they move, which does not happen often. Unlike the broad tracking of repeat sales or changes in rent that leading home price indices analyze, and which are responsive to market changes, CPI: Shelter relies on input from consumers on what they pay to rent or, if homeowners, what they could be receiving to rent their home.
As shown in Figure 2 and Figure 3, “CPI: Shelter” and “CPI: Rent” do not fully account for the same trends in housing costs recorded by other indices. However, research does show a strong correlation between the current growth in housing prices and future rent and OER increases—suggesting that housing inflation will trend upward in the coming months.
Figure 4. Lag in Shelter Inflation
Source: Bureau of Labor Statistics
In December, the annual CPI rate reached an almost four-decade high of a 7% increasef from last year, and the year-over-year Case-Shiller index rose by an all-time high of 20% in August 2021 (compared to the previous year’s rate of 5.9%). The CPI: Shelter component, however, held steady in its month-over-month growth as shown in Figure 4, and has only just started to trend upward as expected. This lack of alignment across measures implies that overall inflation was likely even higher than that captured by the CPI, although shelter is now contributing more to monthly core CPI inflation (which excludes volatile food and energy prices) than it did in 2019 monthly rates.
Because the CPI captures current rents paid (as opposed to advertised rents for newly vacant units), and contracts like leases and mortgages typically last 12 months or more, changes in inflation lag real-time changes in housing costs. The investment firm Infrastructure Capital Management estimated that if the CPI more closely tracked with housing prices and its associated investment aspects (as it was prior to 1983 before BLS changed it to the current methodology), the real CPI rate would have exceeded 10%.
Fannie Mae calculated the direct contribution of projected shelter inflation to overall inflation, forecasting for Q2 2022 that shelter would contribute 1.5 percentage points to CPI (about 0.5 percentage points higher than in 2019). By the end of 2022, they expect that housing could contribute more than 2 percentage points to core CPI inflation, which would be the highest contribution since 1990.
Recent increases in housing costs are rooted in disruptions to both the supply and the demand side of the market. While these economic forces are not new, their effect has been exacerbated by the pandemic.
On the supply side, the rate of home construction in the U.S. fell by 0.7% in October, as rising costs for key construction materials have made it more expensive to build homes. The cost of copper wire has grown the most exponentially—156% in year-over-year growth in October 2021— while lumber increased by 129% year-over-year in June 2021 (the most recent data available). The construction labor force has also not fully recovered to pre-pandemic levels as home builders are struggling to fill open positions. Consequently, key construction labor costs are rising, growing 5% annually in October 2021.
Another problem has been a shortage of available housing lots, which are needed for building single-family homes. Moody’s Analytics found that the cost of land is so expensive that it is approximately 55% of the total price of the median home price nationwide (relative to 45% in 2012), and even above 70% in higher-opportunity areas. Local zoning restrictions also favor single-family homes over the development of multifamily homes, undercutting the potential supply of affordable housing.
These supply constraints make it hard to meet the current, heightened demand for homes. Some of this strong demand may be attributed to pandemic-influenced consumer choices and trends, like the number of households moving away from urban centers into suburbs. But there may be other forces at play as well—including historically low mortgage borrowing rates and strong household saving, especially early in the pandemic, when households cut spending. The mismatch between constrained supply and increased demand in the housing market will likely keep up the pressure on prices.
Economists predict that the recent spike in housing prices will be reflected in future CPI readings, perhaps in early 2022. For example, the White House predicted in September that the monthly CPI would soon reflect higher housing prices by several basis points in the months following. Still, they projected that this growth could simply reflect the pre-pandemic effects of shelter costs on inflation, and that inflation forecasts are expected to slow in coming quarters.
In its November housing forecast, Fannie Mae said that the third quarter of 2021 was likely the peak of the housing price surge, but that housing market inflation would continue through 2022, with housing inflation only falling to pre-pandemic levels (down to 5% from 19.7%) in 2023. Figure 5 shows the predicted rise in housing prices and the subsequent increase in housing inflation indices.
The Federal Reserve’s recent announcement that its efforts to combat continuing inflation projects raising interest rates three times in 2022 will also play a key role. These increases, which are forecast to begin as soon as March, are expected to make borrowing for home and car purchases more expensive and therefore weaken demand for these goods. Real estate economists predict the Fed’s actions will increase mortgage rates from their pandemic level of 3% to 3.6% (still lower than their pre-pandemic rates of 4%), begetting a slower price growth than seen in 2021. Therefore, while experts predict that home prices will continue to rise modestly through 2022, the higher mortgage rates will temper their pressure on the skyrocketing inflation witnessed through 2021.
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