The August CPI report that came out last Tuesday was the catalyst for a sharp market reversal. The headline number was a benign 0.1%, helped by falling gasoline prices. But the “core” number (ex food and energy) came in at 0.6%.

There were several factors, but chief among them because of its high weighting was shelter at 0.7%. which has a 32.3% weighting in the CPI. Food is 13.5% energy is 8.8%. When these two are removed to create the core figure, shelter’s weighting rises to 39.8%.

Within the core CPI number, Shelter is made up of Rent (9.3%) and Owners’ Equivalent Rent (OER, 30.5%), on which we have written before (see Why You Can’t Trust Reported Inflation Numbers). Two thirds of American households own their home. But the economists at the Bureau of Labor Statistics (BLS) want to separate out the service that a home provides (shelter) from its value as an asset.

To estimate OER, BLS statisticians survey homeowners to ask what they think they could rent their home for in the current market. The huge problem with this approach is that few of us give the matter much thought. Homeowners generally know what their home is worth, but you won’t hear cocktail chatter about how the imputed rent on one’s townhouse suddenly shot up.

Home ownership is the prevailing choice of shelter in America. Therefore, OER has a substantial weight in the BLS assessment of living costs, even though uniquely within the CPI it’s not based on cash transactions.

The shortcomings in OER are about to complicate monetary policy.

In theory, if home prices are rising this should cause rents, including the OER, to rise as asset owners seek to maintain their return on investment.

Everyone outside the BLS knows real estate has been hot. Home buyers have regularly been required to pay over the asking price to get a deal done. The S&P/Case-Shiller U.S. National Home Price Index (C-S) has reflected this, increasing year-on-year at 18% as of June (the most recent figure available).

There are signs that the tight real estate market is moderating. The C-S index was rising at 20.6% in March and April. By contrast, OER is now rising, although as the long-term chart shows it fluctuates less than home prices.

But what’s really interesting is that OER is a lagging indicator. From 2000-2020 one year returns on C-S and OER have a correlation of only 0.35. Lagging OER improves the fit, and it turns out the 18 month lagged OER has a correlation of 0.75 with C-S.

The reason is likely that home owners are slow to convert changes in home prices into revised OER, because OER doesn’t affect them. Nobody pays OER. It takes over a year of rising (falling) home prices to show up as an increase (decrease) in OER. Homeowners have a slow reaction function. Inconveniently for the BLS, most of us just don’t think much about renting out our home.

This highlights a significant weakness in how the Fed assesses inflation. The rise in OER they’re observing today is a delayed reaction to the rapid house price appreciation the rest of us have been watching since the beginning of the pandemic in early 2020. Back then, the Fed didn’t see housing inflation because OER didn’t reflect it. Belatedly, it is showing up in the CPI.

Because the history of OER shows it reacts to home prices with a substantial lag, this means the shelter component of CPI is likely to look worse in the months ahead. Its large weight in the core CPI will keep this measure elevated. In this respect, it’s fair to say that the Fed is fighting the last war. In their public comments FOMC members have been very clear that they are looking for a sustained drop in inflation. It was higher than they thought six months ago, if not for the lagged feature of OER.

The fact that inflation expectations remain surprisingly moderate doesn’t appear to be an important consideration.

Core CPI is unlikely to fall substantially while OER is rising. Although the Fed prefers the Personal Consumption Expenditures deflator because of its dynamic category weightings, OER is used there too.

The inverted yield curve for interest rate futures makes more sense when you consider the slow reaction function of OER survey respondents. As long as the Fed uses this measure of housing, they’ll be relying on an echo of the past rather than real time. Based on the historical relationship between C-S and OER, the shelter component of the inflation statistics likely won’t peak for another year. It means the Fed is more likely to make the mistake of maintaining high rates for too long by relying on stale inflation data for shelter.

Only an economist could love OER. It’s about to play an outsized role in monetary policy for all the wrong reasons.

We have three funds that seek to profit from this environment:

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.

Important Disclosures

The information provided is for informational purposes only and investors should determine for themselves whether a particular service, security or product is suitable for their investment needs. The information contained herein is not complete, may not be current, is subject to change, and is subject to, and qualified in its entirety by, the more complete disclosures, risk factors and other terms that are contained in the disclosure, prospectus, and offering. Certain information herein has been obtained from third party sources and, although believed to be reliable, has not been independently verified and its accuracy or completeness cannot be guaranteed. No representation is made with respect to the accuracy,  completeness or timeliness of this information. Nothing provided on this site constitutes tax advice. Individuals should seek the advice of their own tax advisor for specific information regarding tax consequences of investments.  Investments in securities entail risk and are not suitable for all investors. This site is not a recommendation nor an offer to sell (or solicitation of an offer to buy) securities in the United States or in any other jurisdiction.

References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index and do not reflect the deduction of the advisor’s fees or other trading expenses. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase. Indexes and benchmarks may not directly correlate or only partially relate to portfolios managed by SL Advisors as they have different underlying investments and may use different strategies or have different objectives than portfolios managed by SL Advisors (e.g. The Alerian index is a group MLP securities in the oil and gas industries. Portfolios may not include the same investments that are included in the Alerian Index. The S & P Index does not directly relate to investment strategies managed by SL Advisers.)

This site may contain forward-looking statements relating to the objectives, opportunities, and the future performance of the U.S. market generally. Forward-looking statements may be identified by the use of such words as; “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of any particular investment strategy. All are subject to various factors, including, but not limited to general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting a portfolio’s operations that could cause actual results to differ materially from projected results. Such statements are forward-looking in nature and involves a number of known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples. None of SL Advisors LLC or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made. r

Certain hyperlinks or referenced websites on the Site, if any, are for your convenience and forward you to third parties’ websites, which generally are recognized by their top level domain name. Any descriptions of, references to, or links to other products, publications or services does not constitute an endorsement, authorization, sponsorship by or affiliation with SL Advisors LLC with respect to any linked site or its sponsor, unless expressly stated by SL Advisors LLC. Any such information, products or sites have not necessarily been reviewed by SL Advisors LLC and are provided or maintained by third parties over whom SL Advisors LLC exercise no control. SL Advisors LLC expressly disclaim any responsibility for the content, the accuracy of the information, and/or quality of products or services provided by or advertised on these third-party sites.

All investment strategies have the potential for profit or loss. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client’s investment portfolio.

Past performance of the American Energy Independence Index is not indicative of future returns.