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Markets and economy

Inflation, shelter, and a looming recession

A downturn in the housing market will finally ease rental prices next year, helping inflation fall toward the Fed’s target.
5 minute read
December 05, 2022
Markets and economy
Market & economy insights

Headline rates of inflation have peaked in the United States. But while increases in the aggregate prices of goods and services will ease in 2023, some imbalances in supply and demand—notably, for shelter—will keep broad measures of inflation elevated. The descent toward the Federal Reserve’s 2% target will be slow.

Those and more of our expectations will appear in Vanguard Economic and Market Outlook for 2023: Beating Back Inflation. We’ll issue our detailed outlook in mid-December, but a preview is available now. It includes forecasts of inflation and other key economic indicators as well as of 10-year annualized investment returns.

The Fed’s rate-hiking cycle approaches its end

“We do not expect Federal Reserve policymakers to meet their objective for price stability in 2023, though they’ll come closer,” said Asawari Sathe, a senior economist in Vanguard Investment Strategy Group. “In the meantime, inflation risks remain to the upside. That’s because the prices of services will keep accelerating even as goods prices come down.”

In our base case, we see a recession—in the United States and globally—arriving next year. An attendant decline in demand should help bring inflation in the U.S. down to 3% by the end of 2023.1

We expect the Fed’s target range for short-term interest rates to end 2023 at 4.5%–4.75%. It currently stands at 3.75%–4%.

The role of shelter in ‘sticky’ U.S. inflation

Shelter presents a bit of an economic paradox. U.S. housing market activity has been slowing for 1½ years. Yet rents continue to climb quickly and related lodging costs remain volatile, contributing to still-too-high rates of headline inflation.

On the slowing-activity front, the U.S. Commerce Department’s Bureau of Economic Analysis (BEA) estimated that over July through September, the housing market contracted for a sixth consecutive quarter. And the downturn (–26% on an annualized basis) accelerated for a third straight quarter, according to BEA’s first reading of third-quarter gross domestic product.

As for costs, the shelter component of the Consumer Price Index (CPI) rose 0.8% in October—its largest monthly change in more than 30 years, according to the U.S. Labor Department’s Bureau of Labor Statistics (BLS). Shelter accounted for more than half of the CPI’s 0.4% monthly rise, BLS reported. Over the 12 months ended October 31, the cost of shelter increased 6.9%.2

A slower housing market now, reduced inflationary pressure ‘tomorrow’

The source of the housing-activity-down-yet-shelter-costs-still-rising paradox is a lag between construction activity and rent levels. The latter include actual rents paid and “owners’ equivalent of rent” that economists employ to estimate ongoing costs for homeowners. It typically takes 12–15 months or more for a meaningful change in housing activity to translate into higher or—in this case—lower rents.

Both traditional and alternative data suggest a slowdown in shelter inflation only after mid- to late 2023, keeping core inflation elevated at year-end 2023

Month-over-month percentage changes in owners’ equivalent rent

Notes: Owners’ equivalent rent (OER) is represented by a CPI subcomponent, owner-imputed rent, which holds the highest weight in core CPI. Traditional leading indicators of OER are based on a Vanguard proprietary model used to forecast changes in OER. Alternative leading indicators contain public data from private rental and housing firms.

Sources: Vanguard calculations, based on data from Zillow, Apartment List, the Bureau of Labor Statistics, the U.S. Bureau of Economic Analysis, Refinitiv, and Moody’s, as of October 31, 2022.

The COVID-19 pandemic induced a slowdown in construction, exacerbating a housing shortage in the U.S., Sathe said. The shortage helps explain why shelter costs now account for a larger share of headline rates of inflation.

The Fed’s financial tightening and the related rise in mortgage rates have slowed housing activity this year. The decline in housing prices will eventually filter into lower rents, albeit with a significant lag, Sathe said. A new economic downturn—one not driven by health concerns—could ease inflationary pressures, though renters may not see the benefit for another year.

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1Our forecast is for the rate of year-over-year, fourth-quarter change in the Personal Consumption Expenditures Price Index, a preferred gauge of the Federal Reserve.

2We refer specifically to the Consumer Price Index for All Urban Consumers and subcomponents of that index.

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