Carson Investment Research just released its 2023 outlook, which we titled “The Edge of Normal.” The big theme for 2022 was higher-than-expected inflation, which surged to the highest level since 1981. This resulted in the Federal Reserve embarking on its most aggressive rate hike cycle in 40 years, which led to an ugly 2022 for investors – with stocks and bonds falling more than 10%.
At the same time, we are optimistic about 2023, mostly because we believe this year may actually be disinflationary, with several factors that drove inflation higher last year reversing now. Amongst the three major drivers of lower inflation in 2023:
- Gas prices as a deflationary force over the short term
- A reversal of core goods (ex-food and energy) prices
- Shelter inflation pulling back in the back half of the year
In this blog, I want to focus on the third leg, i.e., shelter inflation, because that is what will ultimately drive inflation lower and, most importantly, keep it low. Especially core inflation (ex-food and energy), since shelter makes up 40% of the core CPI basket.
The good news is that market rents are decelerating quite rapidly. Data from Apartment List showed that rents have declined for four consecutive months now. Rents fell 0.8% in December, which is the largest m/m decline they’ve seen in the month of December.
On a year-over-year basis, market rents peaked at 18% at the end of December 2021. The pace is down to under 4% as of last month. Now, as my colleague Ryan Detrick and I have discussed in the past, official shelter inflation data is not going to capture this deceleration for another 8-10 months (see here and here). That is because private data looks at only market rents as related to new leases. But renters do not renew their leases every month. So official data consider both existing and new leases – which means there is a lag. On top of that, official data also average the data over several months to smooth it out.
But there is even better news on the horizon for shelter inflation.
More supply is coming
The housing data look awful, thanks to activity cratering amid the surge in mortgage rates. However, this has mostly been concentrated in the single-family housing segment. Dynamics within the multi-family have been markedly different.
Multi-family units under construction are well-outpacing completions and are currently at their highest level since 1973. Typically, construction outpacing completions would be a sign of over-building, as in the mid-2000s amid the housing bubble. This time around, it is because of supply-chain issues and labor shortages. But these appear to be improving.
This means there are a lot more rental units that may come onto the market, perhaps by late 2023 and early 2024. And we believe that will put even more downward pressure on rental prices.
Of course, all this is going to take a while to show up in the official data, but it further strengthens our view that disinflation is coming – with the largest component of the CPI basket, i.e., shelter, driving that downtrend in late 2023 and even into 2024.
Critically, the timing of this will also likely coincide with a period when the impact of lower goods prices begins to wear off (barring any unexpected shocks). And with shelter inflation on the decline, the Fed may be less likely to argue that disinflationary trends are temporary or “transitory” in Fed speak.
As a result, we could potentially see the Fed start to cut rates in response, though this is unlikely until the very end of 2023, if not early 2024, unless the economy plunges into recession before that. But that is not our base case currently, for all the reasons we discuss in our outlook. You can also listen to us discuss the outlook on the latest episode of the Facts vs. Feelings podcast, “The Edge of Normal.”