On May 12, Don’t Forget the Correction of Understated Shelter Costs

The report from the Bureau of Economic Analysis on the “core” inflation rate for personal consumption expenditures (PCE) in March was concerning. The monthly change in that price index was 0.4% for the third consecutive month, for a 3-month annualized change of 4.4%! The 12-month change climbed from a recent low of 2.7% in October to 3.2% in March, well above the Fed’s 2% objective. And don’t forget: the 12-month change understates inflation, given how the Bureau of Labor Statistics (BLS) treated shelter costs last October when a partial government shutdown prevented the agency from conducting its monthly survey of consumer prices.

A refresher. Lacking data for many items, BLS assumed their prices in October were unchanged from September. For most items this understatement was corrected the following month when November’s prices were correctly recorded, except for the price index for shelter costs.

BLS calculates the monthly percent change in shelter costs as the 6^th root of the percent change in shelter costs over the previous six months reported for one of six rotating panels within a larger sample of housing units. So, lacking survey data for October, the BLS assumed that shelter costs in October were the same as in April – the last time the panel scheduled to be surveyed in October was in fact surveyed – and then calculated October’s change in shelter costs as the 6th root of 0…equals 0! This understatement won’t be corrected until that panel is surveyed again in April. Until then, any change in shelter costs calculated over a span that includes October is missing a month of shelter cost inflation. If that span is less than a year but the change is annualized, then the understatement is annualized as well.

Let’s put numbers to this. The 6-month change in shelter costs was not recorded in October, but it was 1.65% (not annualized) in September. Let’s take that as an estimate of the true 6-month change in shelter costs for the panel that would have been surveyed had the government not been shut down. This implies that the price index for shelter costs has been low since October by 1.1065^1/6 – 1 ≈ 0.3%. Shelter costs have a relative importance of 35% in the consumer price index (CPI), implying that the CPI currently is low by 0.35*0.1% ≈ 0.1%, as is the 12-month percent change in the CPI.

On May 12 the BLS will release the CPI for April. No doubt it will show pronounced effects of higher energy prices, both direct and indirect, resulting from the closure of the Strait of Hormuz. However, it will also include the correction of the understated level of shelter costs. That correction will add approximately 0.1% to both the monthly and the 12-month percent change in the CPI, and slightly more than that to the corresponding measures of core CPI inflation. The impact on the price index for core PCE is roughly half this, given the smaller weight of housing in PCE than in the items covered by the CPI. So not only will the correction for the understatement of shelter costs boost reported inflation, it also will push the monthly change in the CPI above that for the PCE price index. None of this is earth shattering, but it is another reason to expect May’s inflation numbers to be unfavorable.