Markets have quickly grown fearful of inflation re-accelerating in 2025. Inflation break-evens (which estimate what average rates of headline CPI inflation will be for the next 5 and 10 years) have notably ticked up again and reached the upper bound of the 2-2.5% range they've oscillated between since early 2023.

While there are certainly some good explanations for this (tariffs putting pressure on goods prices, immigration policies putting upward pressure on wages, AI putting pressure on electricity prices, etc.), people seem to have conveniently forgotten that the biggest component of CPI--shelter--actually has a favorable outlook for at least the next couple of years, and especially for 2025.

As we mentioned in a recent post, Americans were feeling particularly grumpy about the economy the last several years. Consequently, there was a frequent tendency to have the following exchange:

Person A: Inflation has slowed considerably over the last several years!

Person B: Maybe that's true, but prices are still way above where they were in 2019.

Person A: Yes, but so are your wages and incomes!

Person B: Some people's might be, but mine aren't.

The natural response from Person A in that last exchange should be, "well, where is all this data indicating otherwise coming from?" But typically, Person B shrugs their shoulders, says the government data is wrong, or some combination of the two. And the conversation would end there.

We too have talked before about macro economic data from the government being seemingly disconnected from the real economy in the Post COVID world, but the real sanity check has been commentary from publicly traded companies, which have very much corroborated the growth in wages over the last several years. Just ask Wendy's (Ticker: WEN) or any other fast food company about this and they'll tell you wage inflation was very real. Or look at data from Bank of America's customer account data. It tells the same story.

This is similar to what's happening in the shelter market as well. We've talked (routinely) in our monthly inflation posts about how the Consumer Price Index's (CPI) Shelter component carries with it a considerable lag in its observed prices component (we haven't talked as much about the imputed portion of Shelter CPI, but that's another post for another day). As the chart below shows, shelter inflation in the real economy has slowed considerably since 2022. Rents have basically been flat to down since 2022, and according to ApartmentList's latest national rent report, rents nationally are 4.8% below their August 2022 peak, and 19% higher than December 2019. Home price growth has slowed considerably as well. Using Case-Shiller as a proxy, the latest reading indicated home prices were 3.6% higher year-over-year, and up 6.8% from August 2022 as well. The housing boom days of COVID are very much in the rear-view mirror.

Why has this happened? To some extent, both markets have cooled because of the old adage, "the cure for high prices is high prices." High prices have not only curtailed demand, but they've also incentivized new supply. Consequently, the inventory situation in both single-family and multi-family (apartments or similar) has gotten much better, and this has also put downward pressure on prices. (Note: in the first two charts below, National Association of Realtors data, which isn't easy to access for free, can be found in the HUD Housing Market Indicators Monthly Update reports here).

Realtor.com also gives us helpful data in this regard, showing us active listing counts by year going back to 2017. This also shows that the inventory situation is getting better in single-family homes (December 2024's listing count was up 22% year-over-year), but structural factors like land-lock effects may prevent us from getting all the way back to pre-COVID absolute levels of inventory until rates fall.

While there aren't directly comparable statistics in the multi-family (rental) side of the market, the below charts help tell the same story: significant newbuilds have come into the market, and that new supply has put downward pressure on rents. In the chart below, focus on the middle (purple) line for multi-family, and notice how elevated it got relative to prior cycles (whereas single-family still never even reached building levels we saw in 2005-06). This has resulted in a significant amount of new units hitting the rental market over the last several years, which has been the key reason why rent inflation has collapsed.

Here's two other notable charts from ApartmentList: their Apartment Vacancy Index, as well as their new Apartment Time on Market data. Both show a soft rental market, with vacancies at multi-year peaks, and apartments for rent on average sitting at the highest for the longest levels since at least 2019. The rental market has fully normalized at this point, and likely gone beyond that in many cases.

Redfin did a similar analysis recently that showed that new apartments are filling up at the slowest pace since the depths of COVID. 2Q24's 52% 3 month absorption rate matches the lowest absorption rate since at least 2012. The National Association of Homebuilders Eye on Housing blog recently did a similar analysis and found that 6, 9, and 12 month absorption rates have all returned to pre-COVID levels (or lower) as well (the second and third chart below reflect data from that analysis).

As we've talked about in our monthly inflation reports, private market shelter indices have all rolled over considerably now as a result. Considering these favorable supply demand outlooks, and also considering the lag in the shelter component of the CPI (shown clearly in the chart above), it seems quite likely that both shelter prices in the real economy and in the CPI are going to continue to struggle going up. Let's pull the new construction chart up again, and this time specifically focus on where the purple line is relative to 2019.

This likely means that rents may come under even more pressure in coming months, especially given where vacancies are and given how long apartments are already sitting on the market before getting leased. Similarly, with mortgage rates rising again of late, and single family homes already sitting on the market for about as long as they were pre-COVID, downward pricing pressure could easily get worse. Household formation has almost certainly created a lot of pent-up demand, so it's probably unlikely home prices fall that much, but for our purposes, just having them not go up by much would do a lot to help the interest rate picture.

Which brings me to how the soft shelter inflation might affect CPI. Below I've created a "mark-to-market" shelter core CPI index, using the data from ApartmentList, Realtor.com, CoreLogic's Single Family Rental Index, Case-Shiller's home value index, etc. I use a simple average for now, for simplicity's sake, though that will likely evolve over time as I fine tune it. Considering most of the benchmark private data is telling us the same thing, however, methodology isn't going to be a huge issue right now. Here's how my market-based shelter index would compare to CPI's Shelter index.

As you can see from the chart, according to the CPI, shelter is still inflating at roughly 4.5% in the economy, whereas the private market data figures are indicating shelter inflation is basically near zero. Private market figures, for a variety of reasons, went way higher and peaked way sooner than CPI's shelter index, but given the fairly precipitous fall, CPI shelter is now starting to follow suit. But was the pre-COVID portion of the chart shows, these two generally follow each other fairly closely, so if the market-based shelter index is a reasonable guide, CPI shelter will likely be subdued for a long period of time, and probably sooner rather than later.

With this new market-based shelter index in hand, we can insert this into the CPI to see how it would change our calculations for core CPI in total. Here I take core goods and services ex. shelter as the CPI provides them to us, and make no other adjustments to those categories. I use all the same weights, and simply look at those categories year-over-year. Then in place of the CPI Shelter component, I insert our market-based shelter index to produce a "mark-to-market" core CPI. The result of this is that CPI would have been about 1% on a year-over-year basis in November in aggregate, in contrast to the 3.3% core CPI year-over-year increase that was reported for the month. Obviously, this is a very significant difference, and the point here is that this was entirely due to shelter. Just as significant is that November was not a one-off thing. Using this methodology, "mark-to-market-shelter-adjusted core CPI" has been below the Fed's 2% target since May of 2023. We're at 2% folks.

Thus, if the outlook for shelter cost inflation remains subdued, the outlook for core CPI inflation is probably quite a bit better than we're expecting. As ApartmentList has reminded us, methodological differences are the biggest driving factor between shelter prices in the real economy and the CPI. That will not persist forever, and this has already started to correct.

Unless goods and services inflation meaningfully accelerates then, the overall outlook for inflation should be quite good as well. In the core CPI, shelter accounts for about 45% of the weight, while core goods is about 23% and services ex. shelter is about 31%. As we've talked about in prior posts, goods inflation has been historically near zero, and that has been the case for most of the last three years as well, as supply chains have normalized and consumers have shifted their spend back to services from goods. Beyond the risks around new tariffs from the Trump Administration (which in theory will be mostly one-time), there's not a lot to suggest that will be significantly different going forward. Services ex. shelter, by contrast, have been inflating at about 4.5% on a year-over-year basis the last 3-4 months. The below sensitivity table shows what core inflation would look like using 1% for year-over-year shelter inflation, which is actually well above of the -0.87% market-based shelter our index calculated in November. I do this to be a little more conservative. You can then pick your assumptions for how much goods or services will inflate in 2025 and beyond and get yourself to a fully baked and market-based core CPI.

As you can see from the table, both goods and services inflation can meaningfully tick up before aggregate inflation really accelerates again so long as shelter inflation remains subdued. You can have 5% or higher services inflation (so notably above today's levels) and goods inflation at 2% (also well above where we are today and also well above compared to historical levels as well) and you are still only at 2.5% in aggregate. That's a good position to be in.

In summary, there are reasons to be nervous about inflation re-accelerating in coming years. Most of incoming President Trump's policies are likely to be inflationary to a certain extent. But that is different than saying inflation in aggregate will re-accelerate again. What is routinely being forgotten now it seems, even by the markets, is how important shelter inflation is in the total inflation indices, and in addition to that, how favorable the outlook for shelter inflation is for both 2025 and beyond, especially in the CPI. If that somehow changes, we'll be much more warranted to get very concerned about inflation in aggregate re-accelerating again. Given the outlook for shelter inflation remains so subdued, however, we're probably in a lot better shape going forward than we realize.