The issue of shelter inflation remains a significant concern for both consumers and the Federal Reserve. The recent resurgence in the housing market has the potential to exacerbate this problem, leading to a headache for the central bank.

Inflation Surprises, Prompting Market Reaction

On Tuesday, stocks experienced a drop and 10-year Treasury yields rallied as inflation figures surpassed expectations. The latest data from the Bureau of Labor Statistics revealed that the sticky shelter category, which increased by 0.6% from the previous month, accounted for two thirds of the overall monthly price rise. This reading marked the highest level since September.

Puzzling Persistence of Shelter Inflation

Lawrence Yun, Chief Economist at the National Association of Realtors, described shelter inflation as a significant factor driving stubbornness in relation to the Fed’s inflation target. However, this raises a mystery since apartment rents are no longer rising significantly and single-family rent growth remains at low single-digits.

The slow response of inflation data to changing conditions in the rental market is partly due to the nature of the CPI shelter measure. Unlike other cost metrics and industry data, rents do not fluctuate with market prices. Most households only experience rent changes once a year when their lease comes up for renewal, and the Bureau of Labor Statistics collects price data from each unit included in the index every six months.

While shelter costs in January were 6% higher than the previous year, which is slower than the peak of 8.2% in March 2023, it still exceeds the historical average of 4.2%.

Expectations for Future Trends

Selma Hepp, Chief Economist at CoreLogic, suggests that January’s monthly shelter gain likely reflects strong rent growth during the previous spring. However, Hepp anticipates that shelter inflation will cool off in the coming months. Nevertheless, there is potential trouble on the horizon due to a shortage of homes on the market. The lack of inventory, particularly for single-family homes, affects the measurement of owners’ equivalent rent. Consequently, it will take more time than anticipated to see shelter inflation return to its pre-pandemic average.

Housing Market Shows Signs of Recovery Amidst Rising Home Prices

According to the S&P CoreLogic Case Shiller index data, national home prices experienced a mild decline last year, marking the first decrease since 2012. However, the downturn was short-lived as prices in November, the most recent month for which data is available, were actually 5.1% higher compared to the previous year.

The recent strength in home prices, coupled with a relatively low inventory and indications of increased demand, could pose challenges for the Federal Reserve, warns Torsten Slok, chief economist at Apollo Global Management. Slok, along with Jyoti Agarwal and Rajvi Shah, pointed out in a recent report that home prices are rebounding and the number of cities experiencing positive rent growth is growing. In addition to this, they observed a rise in home purchase loan applications based on data from the Mortgage Bankers Association. These factors suggest a potential housing recovery that may exert upward pressure on shelter costs and subsequently contribute to inflation.

The release of this data has generated concerns among prospective home buyers and builder investors. The 10-year Treasury yield, which serves as a benchmark for mortgage rates, increased by 0.112 percentage point to 4.282%. This marks the highest level since December 5th, as reported by Dow Jones Market Data. The surge in Treasury yields could result in higher mortgage rates prior to the typically bustling spring home buying season which traditionally commences around Presidents Day weekend.

Investors in home builders have also been affected by this development. The iShares U.S. Home Construction exchange-traded fund witnessed an early afternoon decline of approximately 3%, surpassing the S&P 500’s 1.2% drop.

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