Except for one month in 2008 when oil was going parabolic to $150 per barrel, the June 2021 consumer price index (CPI) increase of 5.4% was the highest increase that we have seen in 30 years.
That turned more than a few heads, including mine. I’ve never seen an inflation reading like that in my adult life.
My generation has lived a charmed existence of low inflation and rock-bottom interest rates.
We got to take on massive mortgages to purchase the biggest houses possible – and then we got to refinance those mortgages at even lower rates when interest rates declined.
For my heavily indebted generation, an inflation reading like we saw in June is a concern.
Big inflation could mean a big rise in interest rates.
Fortunately, Federal Reserve Chairman Jerome Powell had told us not to worry. Mr. Powell believes that this jump in inflation is temporary.
But what I see coming next should keep the inflation reading elevated well into next year, which is going to bring more pressure to increase interest rates…
The Cost of Housing Restrained the Inflation Reading in June!
My concern about increased inflation stems from the cost of shelter, which includes the cost of homes both for sale and for rent.
In the consumer price index, shelter is covered by what is known at the owners’ equivalent rent (OER) metric.
This is an estimate of what American homes could be rented for.
The consumer price index doesn’t factor in actual housing prices. Instead, the OER attempts to capture the change in a homeowner’s estimated proceeds from renting their dwelling.
(Buying a house is considered an investment. Renting is considered consumption, and, therefore, it is relevant to the CPI.)
Either way, the cost of a house eventually gets reflected in what it can be rented for. If house prices go up, so will rents.
In the consumer price index, the OER is a major component, representing 23.7% of the index.
Another 7.6% of the CPI is tied to the actual rental rates on primary residences.
Together, these two items mean that a full 31.3%, or nearly one-third, of the CPI reading is tied to housing rental rates and estimated rental rates.
Yet in June, when the headline CPI number was 5.4%, the OER and rent increase portion of the reading came in considerably lower at only 2.6%.
That means the cost of shelter actually kept the June CPI inflation number from being higher than 5.4%.
That is surprising given that we have all been watching housing prices explode higher.
In June, the median price of a home in the United States was $363,300, which was 23.4% higher than the median price a year earlier.
Yet the OER and rent increase for June 2021 was only 2.6%.
With housing prices skyrocketing, and with housing representing one-third of the CPI reading, I believe our headline inflation number is headed higher.
First, the big increase in housing prices will filter down into the amount the CPI reading estimates that homes can be rented for.
Common sense tells us that the cost of buying a home can’t go up 23.4% with rent costs not following a similar path.
Second, actual rental contracts, which typically last one year, are now resetting.
As those rental contracts are renewed, they will start reflecting the new reality: significantly higher rental rates.
It generally takes about five quarters for trend changes in measured rental and home prices to appear in the CPI data.
That means, in the coming months, instead of muting the CPI inflation reading, the housing component will be pushing it higher.
We’ll get a steady string of headline inflation numbers that are much higher than we have seen in a long time.