Bond investors cheered the December U.S. Consumer Price Index (CPI) data released on January 12. Headline inflation came in at 6.5% year on year, which was much better than the previous month. Core inflation receded from 6.0% to 5.7%. There was, however, one discordant note: rents continued to soar.
Rents and Owners’ Equivalent Rent jointly constitute 31% of U.S. CPI, and these costs accelerated in December to 7.5% year-on-year from 7.1% in November. While the pace of increase in home prices has decelerated markedly since peaking in May, rental costs continue to increase (Figure 1).
Figure 1: Rental costs continued to soar in December to a 7.5% annualized gain
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The acceleration in home rental inflation is not entirely surprising for several reasons:
- Rental costs tend to follow the cost of buying a home with a lag of one to two years (Figure 2).
- Mortgage rates have doubled from 3% to 6%, forcing many would-be home buyers into the rental market (Figure 3).
- Rental vacancy rates remain near their lowest levels since the early 1980s, increasing the competition for rental properties. Vacant homes for home owners are also near record lows, adding to the upward pressure on U.S. rental costs by preventing a deeper correction in the price of housing generally (Figure 4).
Figure 2: Rental costs tend to follow the cost of buying a home with a lag of 12-24 months
Figure 3: Mortgage rates have more than doubled from their lows, forcing would-be buyers to rent
Figure 4: Rental vacancy rates near a 38-year low; home-owner vacancy rates close to record lows
While bond investors have been eagerly awaiting signs that inflation is abating in the U.S., the rising costs of rent, their long lags with respect to home-purchase prices and low vacancy rates, represent possible upside risks to inflation relative to expectations. Given that rents are 31% of CPI, if rental costs rise at 7.5% on average over 2023, that would bring CPI to a +2.3% reading (31% x 7.5%) before the other 69% of the index is taken into account. If inflation across the remaining 69% of the index averaged 2%, that would bring total inflation to 3.7% (2.3% + 69%*2%).
While inflation at 3.7% is much better than last year’s 6.5%, it is far above both the Fed’s target and bond investors’ estimate as implied by the difference between yields on standard U.S. Treasuries and Treasury Inflation-Protected Securities (TIPS) (Figure 5). The break-even inflation spread suggests that bond investors anticipate inflation at below 2% in 2023. As such, if inflation were to come in at around 3.5%-4.0% as the rise in shelter costs suggests might be possible, it could come as a major disappointment to U.S. fixed income investors.
Figure 5: TIPS v. Treasuries break-evens imply sub-2% inflation for 2023, but is that realistic?
Even a 3.7% inflation rate might be too optimistic. Over long periods of time, inflation is driven by the gap between wages and productivity. In the past year, wages grew by 4.6% while productivity has been stagnant with growth rates near zero. If CPI, excluding shelter costs, were to rise at a pace of 4.5%, that would imply that inflation might come in as high as 5.4% in 2023 (2.3% from shelter costs plus 3.1% from the rest of the CPI – 4.5% x 69%). Inflation of 5.4% would still be an improvement over 2022 but it would be a major disappointment for bond investors, and could make it more difficult for the Fed to ease policy later in 2023 as the Fed funds curve currently suggests as a possibility.
Moreover, higher inflation, and potentially higher bond yields as a result, could make it difficult for equities to recover their 2022 losses.
It is, of course, possible that wage growth moderates. There have been layoff announcements among big tech firms, and more isolated job cuts taking place among the Wall Street banks. However, as a counterbalance, there is continued strong demand for workers in various service industries. The latest jobs opening and labor turnover survey (JOLTS) suggests that employers in the U.S. are still looking to hire 10.4 million workers. That’s about three million more open positions than in 2019 when unemployment was last at 3.5%. The combination of upward pressure on wages and rents could make reducing inflation to pre-pandemic levels a much more challenging task.
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