This quarter’s theme is based on Newton’s First Law of Motion which states “an object will remain at rest or in motion at a constant speed and direction unless an outside force acts upon it.” There are two critical elements in focus: force and speed. While the law applies to physics, it can also be loosely applied to finance.
When we discuss inflation, for example, we are specifically addressing the rate of change (speed) in prices. To forecast (rather than extrapolate), we need to identify the force(s) that cause prices to change. Unfortunately inflation is often misconstrued as the cause rather than a measure of its impact. Using the economic concepts of supply and demand can help us identify likely forces. Let’s apply these concepts to Shelter Inflation. {As a reminder, Shelter represents 35.5% of Headline CPI and 44% of Core CPI and is a large contributor to today’s high inflation readings.} High vacancy rates (blue line), as we experienced when the housing bubble burst in 2009, meant landlords were forced to lower prices to compete for tenants. In contrast, during COVID, vacancy rates plummeted. Supply shortages forced tenants into bidding wars. The theoretical relationship held, as depicted by Shelter CPI (gold line). Many factors influence shelter prices and vacancy rate alone does not yield a precise forecast. However, it is a statistically meaningful factor and, as the chart shows, very reliable as a directional measure.
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