BIG PICTURE: Betting The Rent On Inflation's Future

-- The cost of shelter is pushing up core inflation to a multiyear high
-- Rental vacancy rates correlate strongly with shelter inflation
-- The Fed still has room, but is sure to be watching core inflation's trend

NEW YORK (Dow Jones)--As shelter goes, so goes core inflation.

When looking at inflation trends, economists and policymakers look at the core prices, which exclude volatile food and energy items. Friday's January consumer price index report showed yearly core inflation stood at 2.3%, the fastest pace since September 2008.

What's behind the acceleration? While some items like apparel and tobacco posted price gains, the cost of putting a roof over one's head is a primary catalyst.

The shelter category--a combination of rents, estimates of what homeowners would pay if they rented their own homes, plus hotel room rates--makes up about 40% of the core CPI. Given that large weighting, shelter prices will largely determine the course of core inflation this year.

The general expectation is that core inflation will moderate this year. If rents pop up, however, say good-bye to moderation.

That could make the Federal Reserve's decision-making harder this year if policymakers are confronted with rising core inflation at the same time the jobless rate remains high.

Ian Shepherdson, chief U.S. economist at High Frequency Economics, notes there is a strong correlation between the change in vacancy rates and inflation for both rents and homeowners' equivalent rent.

The rental vacancy rate has fallen from a record high of 11.1% in the third quarter of 2009 to 9.4% in the fourth quarter of 2011.

Shepherdson says rents have not risen as fast as implied by the fall in vacancy rates so "the danger remains that they will now catch up, posing a risk of rapid near-term acceleration" in rent inflation.

Dan Greenhaus, chief global strategist at BTIG, agrees developments on the rental front must be watched to determine whether "a calm viewing of the inflation landscape is misguided."

Fed officials, who are tasked with holding down inflation while also supporting economic growth, will certainly be watching.

"While the Fed won't react to one data report, several months of strong reports would introduce more caution into their assessment of the need to ease further," said economists at Bank of America/Merrill Lynch.

Relief will come when the increased number of apartment buildings now under construction start taking in tenants. That probably won't happen this year, but should lift vacancy rates--and lower rent inflation--in 2013.