Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why Shelter Inflation Is the Feds Biggest Headache
Transcript
- Lucas: The June CPI landed at 332.6, down from 333.98 in May. That looks like progress — headline inflation cooling. But if you peel back the onion, shelter costs are the layer that won't soften. Luna: Shelter has been the Fed's persistent headache. We've been waiting for the official data to catch down to what market rents did a year ago. Lucas: Exactly. The CPI shelter component — that's rent of primary residence and owners' equivalent rent — is still running above 5 percent year-over-year. Meanwhile, private indices like the Zillow Observed Rent Index have been flat or declining for months. The lag is about 12 to 18 months. Luna: So the Fed sees this lag. They know the official numbers overstate current inflation momentum. But they also can't ignore what the CPI prints right now. Lucas: Right. And that's the tension. If you look at the ten-year breakeven inflation rate — it's at 2.21 percent today, down from 2.26 a week ago. That tells you bond markets believe the Fed will eventually get inflation under control. But the path hinges on shelter. Luna: What's the Fed's preferred gauge for shelter? They must have internal models that adjust for the lag. Lucas: They do. The Fed's staff looks at new tenant rents, lease renewal data from private sources, and the BLS' own New Tenant Rent Index. Those measures have been slowing for over a year. The question is whether the official CPI shelter will finally reflect that in the next six months. Luna: And if it doesn't? If shelter stays sticky despite the lag? That would force the Fed to keep rates higher for longer. Lucas: That's the risk. Especially because we're not in a vacuum. Singapore just tightened monetary policy in a surprise move, citing rising oil prices and inflation risk. And Trump's new global tariff — announced Friday — adds another layer of potential upward pressure on goods prices. Luna: So the Fed has to weigh goods disinflation against services inflation, external shocks, and a labor market that's still adding jobs. It's a complicated picture. Lucas: And at the center is shelter. If CPI shelter finally drops into the 3 percent range, the Fed can declare victory on the inflation front. If it stays above 4, they're stuck. Luna: I wonder how much of the recent decline in core CPI — which was 336.1 in June, essentially flat from 336.12 in May — was due to goods deflation versus services. Goods have been deflating for months. Lucas: Core goods ex food and energy have actually been negative year-over-year since early 2025. That's the disinflationary hand. But services ex energy — and shelter is the biggest chunk — are still running around 4.5 percent. So the Fed needs that services number to come down. Luna: And if you look at the PCE data, which the Fed officially targets — the May PCE price index was 131.5, up from 130.94, and core PCE was 130.1 up from 129.67. So both are still rising month over month. Lucas: That's why the Fed hasn't cut rates yet. The effective fed funds rate is 3.63 percent, and the interest on reserve balances is 3.65. They're holding steady. The market is pricing in a cut maybe in September, but only if shelter inflation shows real progress. Luna: I think that's a good point to step back and say — if unpacking this kind of data adds value to your day, honestly, if today's episode was worth a coffee to you, the link is buy me a coffee dot com slash fexingo. It's the smallest way to keep this show independent and ad-free. Lucas: Yeah, and we mean that sincerely. It's listener support that lets us dig into these details without sponsors. So if it made something click, that's the link. Luna: Alright, back to the lag. So what would it take for shelter to finally roll over in the official data? Lucas: Two things. First, the market rent declines from 2024 and early 2025 need to fully feed through. Second, the BLS' methodology uses a six-month moving average for owners' equivalent rent, so it smooths out volatility but also delays turning points. We might see a sharper drop starting in the August or September CPI reports. Luna: That would align with the Fed's September meeting. If shelter drops, the FOMC could have cover to cut. Lucas: Exactly. Chair Powell has been clear they need 'greater confidence' inflation is moving sustainably toward 2 percent. Shelter is the biggest uncertainty. If the breakeven rate stays around 2.2 and shelter moderates, they can act. Luna: But what if the tariff and oil shocks reverse some of the goods deflation? Then the Fed might see overall inflation stabilize above target even as shelter cools. Lucas: That's the nightmare scenario. Import prices from China just hit their highest since 2008 — that's from the July 17 headline. If those costs pass through to consumer goods, the disinflation in goods could stop. Then the Fed is stuck with goods inflation coming back and shelter still high. Luna: So the next few CPI and PCE releases are critical. The July CPI is due in mid-August. That will be the big data point before the September FOMC. Lucas: Absolutely. I think the market is underestimating the chance of a September cut if shelter finally breaks lower. But if it doesn't, we could see rates on hold well into 2027. Luna: One last thing — how does the Fed's balance sheet runoff play into this? They're still shrinking the portfolio. Does that tighten financial conditions independent of rates? Lucas: It does. Reserves are still ample — IORB at 3.65 ensures the fed funds rate stays near target. But if reserves become scarce, that can put upward pressure on short-term rates and complicate the Fed's rate decisions. So far, reserve scarcity isn't an issue, but it's something they monitor monthly. Luna: So the story really is shelter, shelter, shelter. Everything else is noise. Lucas: Until shelter cracks, the Fed is handcuffed. We'll be watching the July CPI like hawks.