The San Francisco Fed Calls for an Inflation Collapse

By Brett Eversole

I've read (and written) about the word "inflation" more in the past year than in my entire life...

And unless you were an adult in the 1970s, this is probably the most you've heard of it, too.

Inflation is a boring, often misunderstood topic. But it took center stage in the wake of the pandemic recovery. It's the reason stocks crashed in 2022... And everyone has been trying to figure out what it will do next.

Answering that question is difficult, though. Looking at what inflation has done in the past isn't always enough to help us look ahead.

I explained part of the reason why yesterday. We looked at the Federal Reserve's favorite inflation measure – core personal consumption expenditures ("PCE") price index – and why it isn't the same as the headline inflation figure you'll see on the news.

That difference explains why the Fed has kept hiking rates... even though inflation is down dramatically.

Today, we'll dig even deeper. You see, something interesting is happening under the surface... And the Fed's own research tells us that inflation will collapse over the next year as a result.

Let me explain...

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If you want to know where inflation will head next, you need to understand one thing... shelter.

That's because shelter is the only inflation category where you can look at what happened a year ago and know what's coming next month...

You see, shelter inflation – which tracks the cost of keeping a roof over your head – is the single biggest component of the consumer price index ("CPI"). It's calculated based on something called owners' equivalent rent. (That's basically what homeowners would pay if they were renting.)

The problem is, the way the government calculates shelter inflation is flawed...

That's because government data captures rents for all tenants, not just for new leases. But your landlord can't raise your prices until your lease renews – even if rent prices are soaring. That creates a long lag in the data.

Rents skyrocketed in 2020 and 2021. But it took a year for those increases to show up in the data. Later, when rents slowed dramatically, we were stuck with a year of increased shelter costs in the data, thanks to the lag.

Here's where it gets interesting. The San Francisco Fed published a paper in August that not only explained this phenomenon, but also forecast where shelter inflation is likely to go next...

The paper used core CPI, which removes food and energy, for its analysis. That's different from headline CPI... But as the authors note, it tracks core PCE closely (the Fed's preferred inflation measure, which we discussed yesterday).

The authors use asking-rent data to determine future shelter inflation. The details are a bit convoluted – but essentially, they built several models and tested them over time to see which was most accurate.

The final takeaway is astounding... Shelter could end up in deflation by the middle of 2024.

That's right. Not only will shelter inflation slow dramatically, but it could actually turn negative in just a few short months. Here's the forecast from the San Francisco Fed's model...

With shelter making up more than 40% of core CPI – and a large portion of core PCE as well – a negative reading will absolutely crash the overall inflation rate. Even if other inflation categories keep running hot, we'll likely still hit the Fed's 2% inflation target sometime next year.

Of course, this is all a forecast. As the authors note, it can't account for surprise events. But it's not some pie-in-the-sky prediction that tries to guess at the recent data. It's using the data we already have... and that we know will affect shelter over the next year or so.

Fed Chair Jerome Powell knows this is coming, too. He addressed shelter inflation in his speech at Jackson Hole a few weeks ago...

The market-rent slowdown has only recently begun to show through to [shelter inflation]. The slowing growth in rents for new leases over roughly the past year can be thought of as "in the pipeline" and will affect measured housing-services inflation over the coming year.

In short, the Fed believes the fight with inflation isn't over. But it also knows that falling shelter inflation will be a massive tailwind from here.

While the Fed could still hike interest rates, this means its most aggressive actions are already behind us.

That's fantastic news for investors. The Fed's war on inflation crushed stocks last year. The market has risen in 2023... But folks are still scared we'll see a repeat.

If shelter inflation collapses from here – and overall inflation with it – not much will be able to hold stocks back. That's one more reason you should be bullish right now.

Good investing,

Brett Eversole

P.S. With the market's biggest concern fading into the background, this bull market is here to stay. Most investors have a hard time believing that... Heck, they have a hard time believing in this bull market at all.

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You can still watch our discussion covering this story for a limited time. Click here to check it out.