Seeking shelter from shelter inflation

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Katherine Judge: Welcome to CIBC’s Eyes on the Economy podcast. I’m Katherine Judge, a Senior Economist at CIBC. Today is July 15th, and I’m joined by my colleague, Ali Jaffery, who’s a Senior Economist at CIBC. We’re here to discuss a recent paper that he published with Avery Shenfeld titled, Seeking Shelter from Shelter Inflation. Ali, welcome. Let’s start with an overview of what this note is all about.

Ali Jaffery: So we’ve been getting a lot of questions from clients about shelter inflation in both the US and Canada. And so we wanted to do a bit of homework and provide an outlook for shelter inflation over the next year or so for the two countries. For Canada, our focus is on everyone’s favorite subcomponent of inflation here, mortgage interest costs, or what we now all refer very affectionately to as the MIC. And where this component is going to go, given it has such a large weight in total CPI. And we build an empirical model of MIC and combine it with our rate forecast to come up with a view there. For the US, the big question we had in our minds is why three-month and six-month annualized inflation rates of shelter inflation had been moving sideways for most of the past year? And what is the lag relationship between market-based measures of rent in the US, which have come down a lot, and shelter inflation as measured in the CPI. A lot of policy research has emerged on this topic, unsurprisingly from various branches within the Fed. And so we looked at some of this research, their methodologies, and extracted from those models a view of where shelter inflation in the US was headed. The bottom line here for both countries is we expect quite a bit of progress from here until the end of 2025. Of course, there are different reasons for that. In the BOC’s case, it’s more about them cutting rates to bring MIC down. While in the case of the US, it’s about CPI measures of shelter catching up to market rents. And all of this will help with the last mile fairly materially in our view.

Katherine Judge: Interesting. So let’s start with Canada. How much do you expect the MIC component to come down?

Ali Jaffery: We expect MIC to come down a lot. As of May CPI data, which is the latest data we have, it’ll be interesting to see what happens in tomorrow’s June CPI numbers. MIC was running at 23% year over year, adding about a percentage point to headline inflation. We expect that number to fall to about 1% year over year by the end of 2025, gradually to that point and add a little over 0.1 percentage points to inflation. So that’ll be a big downward force on headline prices in Canada. But of course, there’s a lot of uncertainty around this number. What we did is we built a model of the path of variable rates and fixed rates using our forecast of the overnight rate heading back to the BOC’s neutral estimate of 2.75% by the end of 2025, as well as our Bonnie forecast project out these rates. We also made assumptions about lending behavior to weight all of these different rates, projecting that the housing market will look fairly robust and exuberant, sort of like what it did in the middle of 2021, which is where we anchor our model to. Obviously, with the bank easing policy, people with variable rates tend to benefit from gradually lower rates, but those with fixed rate mortgages that are renewing after having very low rates in 2020 and 2021 are going to be entering into higher rates. So these are kind of the two main forces in our model. And so our simulation showed that falling policy rates and somewhat lower yields result in a slowdown in mortgage costs. But on aggregate, they actually don’t contract. So the weighted average mortgage rate will end up slightly higher by the end of 2025. So MIC won’t be a huge drag on inflation. As I’ve said, there’s a lot of uncertainty around this as we don’t have the rich granular data that StatCan does, but some empirical tests we did with our model showed it performed fairly well throughout the pandemic period. So we’re comfortable in saying that, you know, this is a very reasonable guess about the path forward for MIC.

Katherine Judge: You and Avery also found that lower MIC will matter for the bank’s core measures. Can you walk us through that?

Ali Jaffery: Yeah, exactly. So the Bank of Canada often talks about fast growing MIC is trimmed out of its trim mean measure and implying that in some sense, it doesn’t impact core inflation. Now, we disagree with that assessment a bit because, for example, when you include MIC in the calculation of trim, that is, it’s one of the 55 components that they look at, it impacts what other components are trimmed out of, for example, the top 20%. And for median, it affects where the middle of the distribution is, which is what median inflation is. So, for example, if we assume MIC was running at where we think it will average in 2025 in the last May CPI report, that would have pushed down median monthly inflation from the 0.3%, which we saw and which a lot of people freaked out about, 2.2%, which is roughly consistent with target, assuming that you kept all other prices unchanged. That’s not a small difference. Yes, of course, if MIC was lower, the counterfactual should also include possibly higher house prices. But the weight of MIC is now three times larger than the subcomponent that tracks house prices. I don’t think it would provide much of an offset to that 0.1% in a monthly basis. And this is now a bigger problem because the weight of MIC was revised up from about 4% to 6% as of the update to the basket weights in May. MIC is now the third largest component in the basket. So you need to filter out more higher inflation items as MIC falls because the bank is cutting rates to balance that out. In the trim measure, MIC at some point now could account for 10% of CPI trim once it’s no longer in, you know, the top twenty percent or if it doesn’t fall into the bottom twenty percent. And, you know, so to once again be a challenge to determine the signal of underlying inflation. Trim and median might be biased downward in now as a result, you know, because depending on the path of rate cuts and renewal behavior. So that’s why we have long argued that the bank was too hasty in getting rid of its former core measure CPI-ex which drops out MIC entirely from the calculations, so it truly has no impact, as a complement to trim and median. I think these two measures, the bank’s preferred measures, trim and median, in normal times are excellent measures of underlying inflation, and the bank was wise to bring them into the fold as preferred measures. Other central banks like these type of statistical measures, particularly the Fed, with the Dallas and the Cleveland trim mean measures. But other central banks still rely on exclusionary measures of core inflation. And I think the bank should do the same, viewing underlying inflation as the middle of all of these measures, CPI-ex, as well as trim and median, because that’s a safer and wiser option. In past work, we found that CPI-ex is actually not far off from trim and median in terms of the criteria that the bank set out for what constitutes a good measure of core inflation. I suspect they know this and no longer are judging policy entirely on the basis of trim and median.

Katherine Judge: That’s a great point and I agree with that view. For curious listeners, you can refer back to a piece that Ali and Avery wrote in March on the merits of CPI-ex. It’s called, Rotten To The Core: Why Some Old Measures Of Inflation Are Back. But just changing gears a little here, can you tell us about the shelter inflation picture in the US?

Ali Jaffery: Yeah, so this June CPI in the US sort of stole our thunder with a big drop in shelter inflation, which is why we try to get it out the same day. Essentially, our view is that the progress on lower rental and applied rent for homeowners will continue to come down. There’ll be some noise here and there, but the lag between market-based measures of rent and shelter and the CPI is about a year or a little bit longer. And the June CPI report, you know, which saw shelter inflation drop from 0.4 to the 0.1 to 0.2 range. While it’s just one report, it gives us some confidence that the pass through of these rents is going to start to show up more materially. And we base this view on work coming out of the Richmond Fed and the Boston Fed. Both papers have very different methodologies but arrive at a similar conclusion, which is when you average out their forecast of shelter CPI that they expect it to come down to about 3% year over year in about a year as compared to the 5% where it sits right now. Mechanically speaking, that implies Core CPI, which has a very large weight on shelter of about 46%, could be 0.9 percentage points lower than what it is today. Or that means about 2 .5 % year over year by June of next year. While Core’s PCE, which has a smaller but still not insignificant weight of 18% would be down by 0.4 percentage points from its current level to 2.2% which is a hair above the official target. So that’ll help the Fed quite a bit in the last mile. Core PC is sitting now at 2.6% and without housing, if you exclude housing from that, it’s already at 2% on a year over year basis. The decline in shelter will be no small development for the Fed and I think it really strengthens the case for cuts in September and December, which has been our position for quite a while.

Katherine Judge: Great, thanks for that summary on Shelter CPI. And thanks for joining me today, Ali. And of course, thank you to all of our listeners and see you again in two weeks.

Outro: Please join us next time on the Eyes on the Economy where we will share our latest perspectives and outlook for the Canadian and US economy.

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