Why You Shouldn’t Worry About January Inflation Data
On February 13th, the U.S. Bureau of Labor Statistics reported that the consumer price index (CPI) measure of inflation rose 0.3% month-over-month in January, and 3.1% year-over-year. This inflation print was materially higher than consensus estimates for a 2.9% increase.
The news sent equity markets into a volatile session. The S&P closed down more than -1%, and the Russell 2000 index of small-cap stocks—which tends to be growth and interest rate sensitive—sank by approximately -4%. Meanwhile, yields on 10-year U.S. Treasuries jumped.1
In short, it was not the news investors wanted to hear. But I wasn’t worried.
For one, I am not convinced that the bull market is driven solely by expectations for rate cuts, as many pundits suggest. U.S. stocks started rallying in October 2022, which was a time when the Fed was still raising rates aggressively and no one was forecasting cuts. But I’ve also argued that stocks were rallying ahead of better-than-expected economic growth in 2023, and also in anticipation of an earnings rebound I think started in Q3 2023. January’s inflation data, and shifting expectations for rate cuts in 2024, did not change those fundamentals.
The second reason not to worry about January CPI was the outsized role played by “shelter costs.” Shelter costs refer to the cost of housing. Its relative importance in CPI inflation data is huge – making up some 36% of the entire calculation. One subcategory of shelter costs, called owner’s equivalent rent (OER), is responsible for about 25% of CPI.
In the January data, shelter costs increased by +0.6% month-over-month, which marked an acceleration from December’s +0.4% month-over-month increase. Because of its relative importance, this single data point can pull CPI significantly higher for the month.
The question, though, is whether the shelter cost calculation – and in particular OER – is truly reflective of residential housing costs across the country today. I would argue it isn’t.
In order to calculate OER, the Bureau of Labor Statistics’ Consumer Expenditure Survey asks participating Americans the following question: “If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?” While I understand some homeowners do rent their houses out for extra cash, it is also fair to label this question – and the data it produces – as purely hypothetical. It’s a made-up number, but it also has a disproportionately large impact on the CPI calculation.
In my view, the calculation is problematic. Asking homeowners how much they would rent their house for is a strange way to determine housing costs. But we also know from analyzing the data that OER lags actual housing prices by over a year. Even as housing prices began to decline year-over-year in April 2022 (red line in the chart below), OER continued to move higher for about 15 months (blue line in the chart below). If this relationship holds—which I firmly believe it will—we can expect shelter costs to fall by about half over the next nine months, which should have an anchoring effect on the CPI calculation.
Shelter Costs (OER) Lag Housing Prices by Over a Year
The chart below shows the clear effect that high shelter costs are having on the CPI figure. The purple line shows shelter costs while the red line shows headline CPI. Again, with shelter costs making up some 36% of the CPI calculation, it’s clear that elevated readings—which we’ve established are lagging and not necessarily reflective of housing prices across the country—are pulling the CPI number higher. If it weren’t for shelter costs, CPI (ex-shelter) in January would have been 1.6% year-over-year.
CPI (All Items, Red Line) vs. Shelter Costs (Purple Line)
Knowing what we know about housing prices and the OER calculation, we can reasonably predict that January’s 6.2% OER print will fall to under 3% by this fall. With other elements of the inflation data still trending in the right direction—goods inflation, for example, continues to be negative—I think worries about Fed cuts and price pressures will all but fade completely within a few months.
Bottom Line for Investors
As I stated early in this week’s column, the overall outlook for the U.S. economy—whether you look at jobs, consumer spending, corporate earnings, services activity, wages, etc.—continues to be fundamentally positive, even with one month’s higher-than-expected inflation print. Even still, the CPI number may not matter as much as investors think it does. The Federal Reserve’s preferred inflation gauge, the headline personal consumption expenditures (PCE) price index, puts a smaller weight on housing costs than CPI.
Disclosure
2 Fred Economic Data. February 13, 2024. https://fred.stlouisfed.org/series/CUSR0000SEHC01#
3 U.S. Bureau of Labor Statistics. 2024. https://www.bls.gov/charts/consumer-price-index/consumer-price-index-by-category-line-chart.htm
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