Interest Rate Decisions Hinge on Lagging Inflation Estimates

Inflation may not be as high as the government says it is thanks to latency built into the Bureau of Labor Statistics calculation of the Consumer Price Index. Marcus & Millichap SVP of research services John Chang explained the phenomenon in a recent research video.

The CPI analyzes the prices of various goods, including apparel, recreation, education, medical care, food and transportation. The biggest component of CPI is housing costs, which account for 45% of consumer spending. Chang described this calculation as ‘a bit out of proportion’ as the average U.S. household spends between 25% and 30% of their income on housing.

A deeper look into housing costs reveals that 8% of total CPI inflation is driven by rent growth and an additional 27% is driven by owners’ equivalent rent, a somewhat controversial concept among economists. Owners’ equivalent rent is a hypothetical model number meant to represent what a homeowner would have to pay to rent the home they live in, explained Chang. It is based on a renter survey conducted by the Census Bureau of about 5,000 renters each quarter.

This creates a latency issue because most renters are on an annual lease, so their rent changes once a year rather than month to month. This means it can take up to a year for data from the renter survey to capture actual rent movement. As a result, inflation is underreported when rents rise quickly and overreported when rent growth slows, said Chang.

Some economists advocate for eliminating owners’ equivalent rent in the inflation measurement, which would put the current CPI inflation rate at about 2.4% instead of the current reading of 3.3%. Alternatively, using data sources like Zillow to calculate primary residence inflation would put today’s CPI inflation rate at 2.6% to 3%. If headline inflation were down to about 2.6%, the Fed would likely be inclined to cut interest rates, said Chang.

“Basically, the Federal Reserve is setting rate policies based in part on old data,” said Chang. “They’re driving by looking in the rearview mirror.”

The good news, said Chang, is that available data is already showing what the housing component of CPI will do over the next year. Apartment rents only went up by 1.2% in the past 12 months, so housing inflation should continue to fall, he said.