Rents are already falling. Official data hasn't noticed

The shelter index in the US consumer price report rose 0.8 per cent in October, its steepest monthly rise in more than three decades, and no single line in the American economic data is doing more to mislead. Read only the government releases and the rental market looks to be heading into a frenzy. Property operators, real estate technology firms and institutional landlords see an absurd historical artefact. In the market where leases are actually signed, rents have already started falling.

The gap between official statistics and market prices comes from the way the Bureau of Labor Statistics collects its survey. The official shelter measure does not track new transactions. It tracks the average rent paid across the whole existing housing stock, including leases signed six, twelve or eighteen months ago. With mortgage rates at seven per cent and the housing market frozen, relying on that series means monetary policymakers are steering the economy by the rear-view mirror.

How the survey is built

The detail of the method explains the delay. The bureau splits its sample of rented homes into six panels and prices each home only once every six months, then converts the six-month change into a monthly figure. A rise in rent agreed in the spring may therefore not be recorded until autumn, and it keeps feeding into the index for months after that.

Most of the shelter index is not rent at all in the ordinary sense. The largest component, owners' equivalent rent, estimates what homeowners would pay to rent their own houses, and it is imputed from the same rental sample. Home prices do not enter it directly. So the slide in house prices since the summer has no mechanical effect on measured inflation, and the lag in rents is passed straight through to the biggest single item in the core index.

Private indices got there first

Private high-frequency rent indices, such as those from Zillow, Apartment List and other data aggregators, track spot transactions, meaning the rents at which vacant flats are let to new tenants. These indices peaked in late 2021 and early 2022, when annual rent growth reached an unsustainable seventeen per cent. Since the spring of 2022 the direction has reversed. Spot rent growth has slowed at a record pace, and monthly readings have turned negative across major cities over the past two months.

Academic and econometric work finds that spot lease indices lead the official CPI shelter index by about twelve months. The reason is simple arithmetic. Only about eight per cent of tenants sign a new lease in any given month, and the other ninety-two per cent keep paying under existing annual contracts. A change in market rents takes a full year to work through the surveyed housing stock. The shelter inflation now showing up in government tables reflects the housing boom of autumn 2021, and the cooling of late 2022 has yet to appear.

Supply is adding to the pressure on spot rents. Developers who broke ground during the boom have left the country with the largest pipeline of apartments under construction since the 1970s, and those units will be completed over the coming year whatever happens to demand. New supply competes directly for the tenants whose leases set the private indices, which argues for further softness in spot rents before any rebound.

A Fed that overtightens

Shelter makes up thirty-four per cent of the headline consumer price index and more than forty per cent of core CPI, so the lag is a serious hazard for monetary policy. If the Federal Open Market Committee waits for the official shelter measure to slow before it stops raising rates, it will almost certainly overtighten. By the time the lagged government surveys show flat or falling housing costs in late 2023, the Fed will have kept borrowing costs well into restrictive territory for a year longer than it needed to.

For corporate treasurers and bond investors the lag also distorts real interest rates. Swap the official shelter figure for current spot rents and underlying core inflation is already running between two and three per cent, rather than the published six per cent. On that basis nominal interest rates of 4 per cent already push real rates across the business economy well into restrictive territory.

Fed officials know about the lag and have said so in public. Their defence is that private indices are young, cover a narrow slice of the market and have not been tested through a full cycle, so the committee cannot set policy on them alone. That caution is reasonable for a single month's reading. It is harder to justify when every private index points the same way for half a year.

The seasonal objection

The strongest challenge to this argument is the calendar. Rents on new leases usually soften in the autumn and winter, when fewer households move, and pick up again in the spring. Some of the recent weakness in the private indices is seasonal, and a firm spring leasing season could reverse it. Demand also has support: with mortgage rates near seven per cent, many would-be buyers are staying in rented homes for longer.

Those points argue for patience about how far spot rents will fall, not about which direction the official index will take. Even if new-lease rents merely flatten, the arithmetic of the survey guarantees that official shelter inflation will slow through 2023 as last year's large increases roll out of the sample. The monthly shelter readings in each coming consumer price report, compared against the private indices, will show how quickly the gap closes.

By declining to adjust for a statistical lag it knows about, the Federal Reserve is steering the economy towards a contraction nobody needed. The Fed is tightening against housing inflation that has already gone from new leases, and the slowdown it produces next year will probably be deeper than it had to be. Investors who understand the twelve-month rent lag should expect headline inflation prints to fall abruptly once the government's calendar catches up with the market, most likely from the spring, and should expect the Fed to take credit for a decline it did little to cause.