US CPI: Shelter Suggests More Cooling Ahead

Tuesday’s big news: the US Consumer Price Index (CPI) is a hair above average. After peaking at 9.1% y/y in June 2022, inflation has slowed substantially.^[i] In October, it fell again—from 3.7% y/y in September to 3.2%—a whisker above CPI’s long-term average of 3.0%.^[ii] Headlines’ reaction was a bit, well, strange. Most interpreted slowing inflation as evidence the economy is cooling, which we would classify as finding a cloud in a silver lining. Yet coverage broadly credited the report with stocks’ banner day, which lifted the S&P 500 1.91% and put the index -2.0% below July 31’s pre-correction high in price-only terms.^[iii] Seems to us like a timely reminder not to read into any one day’s wiggles—sentiment is far too fickle to get a proper read on why stocks do what they do on the vast majority of days.

So we will instead focus on another yah-but: Yah, but inflation only slowed because gas prices dropped. Core inflation, which excludes food and energy, remains elevated at 4.0% y/y.^[iv] That is down a smidge from September’s 4.1% and a two-year low, but it is still faster than anyone would like. Yet here is some good news: When you also factor out shelter costs, the inflation rate is down to 2.0% y/y for the second month running.^[v] Downright benign.

Now, we know sliced-and-diced inflation measures like this make people’s eyes roll. We get it—and have often rolled our eyes at them. But in this case, we think core inflation ex. shelter is useful as an indicator of where people can expect normal core inflation to go because the shelter component of CPI lags home prices by nearly a year and a half. Given home prices started rolling over a while ago, it is highly probable that CPI’s shelter component will continue its deceleration from March’s high of 8.2% y/y—and at 6.7% in October, it has quite a ways to go.^[vi] Not only should the owner’s imputed rent category (the fictitious amount a homeowner would pay to rent their own house) continue following home prices’ stabilization, but actual rents should also ease.

We are already seeing signs of the latter. For one, as The Wall Street Journal reported today, Zillow’s index of national rents slowed to 3.2% y/y in September, well below CPI’s rental component (7.2% y/y in September).^[vii] Zillow’s index, which includes new leases only, peaked a year before CPI’s rent index (which aggregates new and existing leases), indicating the latter likely has a big continued slowdown ahead of it. Meanwhile, we have seen abundant anecdotal evidence of landlords offering big incentives to rent out vacant apartments in much of the country, seemingly in hopes of not having to take the longer-term revenue hit by lowering the offered rental price. With a flood of new supply about to hit the market, rents should see further downward pressure. Yes, even if those new units are market-rate or even “luxury,” rather than “affordable.” To the market, supply is supply. In housing-starved areas like Northern California, high-income folks have bid up older apartments to stratospheric levels. New supply, even at the higher end, reduces the competition for older units, helping costs stabilize up and down the spectrum.

None of this is predictive for stocks, despite the many who tied Tuesday’s market action to the CPI report. Markets are forward-looking and have been pre-pricing inflation improvement since the bull market began over a year ago. Yet easing inflation means one less thing pressuring sentiment, which is a positive (if only an incremental one). The less skittish investors are, the more willing they are to take risk, invest and bid stocks higher.