Housing Costs Will Determine Inflation In 2023, Here’s Why

Many components of inflation have eased over the past year, while housing costs have continued to accelerate. However, there are good reasons to expect that to change over the coming months.

Inflation has been among the most closely watched economic variables over the past 2 years and has driven an aggressive increase in interest rates from the Federal Reserve. Recently, annual inflation has fallen from an peak of 9% during summer 2022 to 5% today. However, where inflation trends from here will likely be driven by housing costs. That’s because housing costs make up almost 60% of the Consumer Price Index and are rising at an 8.2% annual rate, according to the March 2023 CPI figures.

At this point, after many other products and services have stabilized, or even started to decline in price, home prices continues to surge within CPI data. When and if that changes it will have a meaningful impact on headline inflation numbers both due to the current large year-on-year price changes for housing and the very large weighting housing costs have in the CPI calculation. Today most of the increase in headline CPI is due to housing costs.

Industry data suggests things are changing already. Home prices have been declining from peak levels since last summer, according to most industry sources such as Redfin and Zillow. In contrast, the CPI calculates housing costs using a panel-based approach. That’s slower to catch turning points in the housing cycle, such as potentially right now.

This enables more homes to be included in the dataset, but the panel-approach also adds a lag of at least six months to the shelter cost index in the CPI. Furthermore, because housing leases are not renewed every month, the lag to current prices may be greater still.

We’ve also seen this historically. Shelter costs in the CPI lagged the S&P Case-Shiller National Home Price Index by over a year during the major housing recession of 2007-2009. A similar trend has been true in recent months. The Case-Shiller index is decelerating as the shelter component of the CPI continues to accelerate.

The ability of shelter costs in the CPI to continue to rise may not last much longer. Federal Reserve Chair Jerome Powell knows this too. In a speech from November 2022 he said, “we would expect housing services inflation to begin falling sometime next year.” Once home prices do start to decelerate in the CPI figures it may be enough to gradually return inflation to the Fed’s 2% target if the recent negative trends in home prices are sustained. The only catch is we don’t quite know when that process will start given the statistical complexity of home price calculations within the CPI figures. For now, it looks like the Federal Reserve will once again raise rates when they meet in May, but a changing trajectory for home prices over the coming months may ultimately enable the Fed to start cutting rates as inflation fears ease.