There has been a pivot in the way Americans live.  When it estimated the U.S. housing inventory for the fourth quarter of 2014, the Census Bureau found that owned homes had declined for the year, while rental units increased by more than 2 million.

Homeownership has fallen to 63.9 percent, its lowest level since 1994. Meanwhile, vacancy rates for rental units hit lows not seen since 1993. In terms of employment and GDP, the economy has certainly made progress since housing bubble burst (though both took longer to get back to normal than most expected). Housing itself, however, has continued to lag.

This shift toward rental housing has already begun to filter through one of the more important, and stagnant, parts of the economic recovery—inflation. Price moves are difficult to track, as are policies surrounding how to measure them. Some price shifts matter more than others. Oil and food movements are volatile, and therefore less important than the movement of clothing and autos. The consumer price index (CPI) places significant importance on the price changes of shelter. Rent and owner’s equivalent rent (OER) make up about 33 percent of the index.

How much is shelter affecting the CPI? Core CPI—all items less the volatile food and energy—is 1.8 percent from a year ago. But remove shelter from this equation and CPI is only 0.9 percent. The price of shelter is up about 3 percent—a significant reason CPI remains in positive territory. This begins to make the “stable prices” mandate and 2 percent Fed inflation target look suspect, and less well targeted than might be assumed.

This is where the shift away from ownership towards rent begins to make an impact.

The calculation of the housing component of CPI is an oddity. The pricing data used to calculate the pricing movements is collected solely from renters—including the data used to compute the owner’s equivalent rent. The Consumer Expenditure Survey asks owners how much rent they would charge for their unfurnished home per month with no utilities. Renters are asked how much their rent is per month and what the amenities are included in the rent. But this CES data is only used to set the weights in the CPI. The prices used to calculate CPI are all from renters. Can you really compute rent of an owned home from a rental unit?

This means the pace of rent increases has a significant effect on the U.S. inflation rate—not simply through the rent line, but through the method of calculating owner’s equivalent rent. Actual home prices do not enter into the equation. If rent does not increase in concert with home prices for idiosyncratic reasons, then home price increases will not be reflected in the owner’s equivalent rent line (which is 24 percent of the index). The converse is also true. If rents are increasing due to Millennials failing to purchase homes and instead bidding up rents, lackluster home prices will have little to no effect on the CPI.

Imagine home prices are increasing. A homeowner asked “How much would the rent on your house be?” will likely estimate a higher figure than before, because of the increasing value. This would increase the weight of the OER in the CPI basket.

As renters shift to being home owners, demand for rental units falls. This would in turn lead to lower rents being charged to tenants. So we end up with a higher weight for OER with a lower rent number. The outcome would be lower shelter inflation—while housing prices are increasing. Costs have not actually declined, but there is inability to distinguish a shift in preferences.

This is crucial to understanding the movements of inflation in recent years. For a variety of well documented reasons, Millennials prefer to rent in cities and live close to work. This has created a renter culture, and rents are moving higher. From this perspective, the current stable core inflation level could be considered the “Millennial Moderation.” The much maligned generational preference for rental housing is likely playing a substantial role in the “reflating” of the economy through the rent mechanism.

The CPI is the most familiar measure of price level movements, and it is used to calculating a host of things including Social Security payment increases, deflating retail sales, and the national product accounts. The measurement of CPI is critical, and this means owner’s equivalent rent is important—not simply because it makes up nearly a quarter of CPI, but because CPI is a critical factor in other economic indicators.

This means there are implications for Fed policy. The measurement and level of CPI is pervasive in economic indicators. The Fed’s mandate is to maintain stable prices, and this means understanding the underlying dynamics of the indicators—especially the indicators that capture headlines and affect everyday economic decisionmaking.

The Fed would normally care little about the internals of the housing market so long as financial stability is maintained. But because of the significance on CPI, the Fed has an obligation to monitor the effects of monetary policy on shifts in housing preferences. The Fed has a habit of insisting that certain economic oddities are simply “transitory.” If high levels of rent inflation are transitory, the Fed’s much sought after inflation pressures might be also.

Typically, higher rates would reduce inflation pressures. But this time, there are no pressures to reduce. With core CPI (less shelter) already running at such low rates, it is important to understand how OER will react to a rise in rates. If it causes rents to decline, this could be an additional headwind for inflation. Higher rates could push the United States into deflation territory. After all, shelter is contributing more than 50 percent of inflation at the moment.

Monetary policy decisions based on CPI, or one of its many derivatives, could be problematic. If rents begin to decline, so will inflation. Even a slowing in rent growth would be problematic for the Fed’s price stability mandate. Without a more broad based increase in the price level, the moderate increase in the core price level will be difficult to maintain, and inflation will fall lower. Understanding this is crucial when evaluating the strength of the U.S. recovery, and the dangers posed by weak inflation.

Samuel Rines is an economist with Chilton Capital Management in Houston, TX. Follow him on Twitter @samuelrines.

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