Latest / Inflation Explained with Fexingo: CPI, Prices, and the Cost of Living for Everyday People / How Your Rent Check Reveals Inflation Math
Transcript
- Lucas: If you've looked at your rent check recently and then looked at the headline inflation number and thought 'those two things don't add up', you're not wrong. Luna: I think a lot of people feel that disconnect. The official number says 4.2 percent for May, but my landlord just raised rent by six. Lucas: Right. And that gap is partly because of how the government measures shelter costs. Shelter is the single biggest component of the CPI — it's about a third of the index. And the way they calculate it is... let's call it unintuitive. Luna: What do you mean? Isn't it just 'what people pay in rent'? Lucas: It is for renters. But for homeowners — and that's roughly two-thirds of households — the BLS doesn't use mortgage payments or property taxes. They use something called 'owners' equivalent rent'. Essentially, they ask: if you owned your home, how much would you pay to rent it from yourself? And then they impute that number into the index. Luna: So they're inventing a rent number for people who don't pay rent? Lucas: That's one way to look at it. And it's controversial, but there's a logic to it. The idea is that a home is both a consumption good — the shelter it provides — and an investment. Mortgage payments mix both. So to isolate the pure 'cost of shelter' consumed, they estimate what the rental value would be. Luna: I can see why that might make sense in theory. But how does that affect the number we actually see? Lucas: Massively. In the May CPI report, shelter inflation was running at 5.2 percent annually. That's down from a peak of over 8 percent in early 2023, but it's still way above the overall CPI. And because shelter is such a big weight, it's keeping core CPI — that's ex food and energy — elevated at 4.2 percent as well. Luna: So the headline number is being dragged up by this imputed rent for homeowners? Lucas: Exactly. Without shelter, core CPI would probably be closer to 3 percent or even lower. But the Fed looks at core as a signal of underlying inflation, so they can't ignore it. Luna: And meanwhile, actual market rents have been cooling in a lot of cities. I've seen data from Apartment List and Zillow showing year-over-year rent growth around 2-3 percent recently. Lucas: That's the key disconnect. New lease rents have moderated. But owners' equivalent rent and the rent of primary residence in CPI are lagging indicators — they reflect the stock of all rentals, including people who've been in the same unit for years. So it takes time for softer market conditions to feed through. Luna: How much time? Are we talking months or years? Lucas: Typically 12 to 18 months. So the slowdown in market rents from 2024 and early 2025 should be showing up in CPI now. And it is — shelter CPI has come down from 5.5 percent in January to 5.2 percent in May. But it's stubborn. Luna: And on top of that, you've got the 10-year breakeven inflation rate — that's the market's expectation for average inflation over the next decade — which just ticked up to 2.31 percent from 2.29. Lucas: Yeah, that's interesting. Even as the Fed holds rates at around 3.6 percent, the bond market is saying inflation expectations are creeping up. That makes the Fed's job harder. If shelter doesn't cool further, they might have to keep rates higher for longer. Luna: So if I'm a renter, what should I expect in the next year? Lucas: Based on the lag, we should see shelter inflation continue to drift lower — maybe to 4.5 percent by year-end. But that's still above the Fed's 2 percent target. And if energy prices stay volatile — you saw wholesale prices jumped 1.1 percent in May on energy — that could spill over. Luna: Let's talk about that wholesale price report. It was hotter than expected. How does that connect to the CPI shelter story? Lucas: The Producer Price Index measures what businesses pay for inputs. When energy costs rise, it eventually filters through to consumer prices, including for things like building materials and utilities. That can put upward pressure on rents, because landlords face higher costs too. Luna: So there's a pipeline from wholesale energy to your rent check. That's a longer chain. Lucas: It is. And the ECB just raised rates for the first time since 2023 because of energy costs tied to the Iran conflict. That shows central banks globally are still on edge about inflation. The Fed is probably watching shelter and energy most closely. Luna: One thing I've always wondered: why doesn't the CPI just use actual market rents for homeowners? Why the imputation? Lucas: Great question. The BLS argues that if you own a home and live in it, you're 'consuming' housing services. To measure the cost of those services consistently over time, they need a rental equivalent. Mortgage payments reflect interest rates, home prices, and leverage — not the pure consumption cost. So they use a survey that asks homeowners: 'If you rented your home unfurnished, how much do you think it would rent for?' Luna: That sounds subjective. How accurate is it? Lucas: It's not perfect. There's a known bias — homeowners tend to overestimate their home's rental value by about 5 to 10 percent. But the BLS adjusts for that using statistical models. The alternative, using actual market rents for similar properties, would introduce other issues — like mixing in different quality homes over time. Luna: I see. So it's a trade-off. No perfect method. Lucas: Right. And this matters for more than just academic interest. The CPI is used to adjust Social Security benefits, tax brackets, and even some union contracts. So the way we measure shelter inflation has real dollar consequences. Luna: Millions of people's cost of living adjustments are tied to a number that includes an estimate of what homeowners would pay to rent their own house. Lucas: Exactly. And that's why it's important to understand the construction of the index, not just the headline. Luna: You know, speaking of the practical side: a couple of dollars a month is genuinely what keeps these episodes going. If walking through the economy with us has made something click, buy me a coffee dot com slash fexingo is a simple way to chip in. Lucas: Yeah, that really does make a difference. No pressure, but listener support is what keeps this show ad-free and independent. Luna: Alright, so back to shelter. If I'm trying to gauge where inflation is headed, what should I watch besides CPI? Lucas: I'd watch the Zillow Observed Rent Index and Apartment List's national rent report. They're more real-time. Also watch the Fed's preferred inflation gauge, the PCE price index — that gives less weight to shelter than CPI does. The April PCE was at 2.8 percent year over year, which is closer to target. Luna: So the Fed is probably more focused on PCE than CPI. Lucas: Yes. But the market still reacts to CPI. And the breakeven inflation rate we mentioned — that's a market-based measure that the Fed watches closely. If it stays above 2.3 percent, they'll be cautious. Luna: Final question: are we ever going to see shelter inflation drop to, say, 3 percent? Lucas: Probably, but not overnight. Demographic demand — millennials forming households, immigration — keeps pressure on rents. And with construction costs elevated due to labor and material shortages, new supply is expensive. I'd guess shelter inflation settles around 3 to 4 percent in the next year, which would still keep core CPI above the Fed's comfort zone. Luna: So the rent check isn't lying — it's just telling a different part of the story. Lucas: That's exactly right. The CPI shelter number is a rearview mirror with a specific lens. Understanding that lens is the first step to making sense of the inflation picture.