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July 13, 2005
Do Rising House Prices Distort Inflation Measurement?
Kash at Angry Bear, in a thoughtful piece posted yesterday, suggests that the answer is yes. When confronted with questions about inflation measurement, my habit is to turn to my colleague Mike Bryan, who knows a heck of a lot more about this topic than I do. Here is what Mike had to say (lightly edited):
1) The idea of the CPI is to measure, as closely as possible, the average person's cost-of-living. Although the BLS doesn't exactly claim that this is their intent, for all practical purposes, that is indeed what they are trying to do. As such, the rental equivalence approach is the "right" approach because it measures the cost of owning a home to a homeowner.
What is the cost of owning a home to someone who already owns a home? Well, it's the opportunity cost of living in your home rather than renting it out. So, in this sense, there is no "mismeasurement" as Kash suggests. The BLS does it correctly (which is always a good assumption since these people are really quite good at what they do.)
Remember, housing is an asset, and for most, rising home prices isn't a direct cost. In the same way, would I ask the BLS to add rising stock market values in their cost of living index? No, of course not. (But rising equity values MAY be a sign of rising inflation, and I will return to this at the end.)
2) There may actually BE a mismeasurement here, but it comes from the fact that, despite the great efforts of the BLS to match the owner-occupied housing stock with a comparable sample of rental homes, rental homes tend to be in less desirable neighborhoods without the same amenities. As a result, when the housing market "heats up" there could easily be a quality shift that makes the BLS sample less conformable to the true owner-occupied market. Work has been done in this area, and the BLS is well aware of this potential "bias."
3) I also have a problem with this bit from Kash's post: "This means that the inflation experienced by people who have bought a house in the past couple of years is probably considerably higher than the inflation measured by the CPI." The CPI weighs housing on the basis of what the average person spends on housing (implicitly via opportunity cost) and not what a new, first-time homeowner spends. Again, if you are already a homeowner (without appealing to opportunity costs), you have NO cost-of-living rise as home prices rise. You bought your home before prices went up. (And remember, you have to be a first-time buyer, or the rising gains from selling your old home will largely offset the rising costs of the new one.)
Now, I don't know exactly what the proportion of the housing market these people represent, but I would bet they are quite small. So, by the approach implied by the blog, one would weigh the CPI housing MUCH smaller than the 23 percent of the basket it currently commands. In fact, I wouldn't be surprised if the downward revision to the CPI from the reduction in the component's weight had a much larger impact than the upward revision to the CPI from plugging in actual new home costs.
4) Now, let's take on the issue I think is most important: Is a cost-of-living approximation like the CPI a good "inflation" measure? I think not and have written on this in many places -- here, for example. The sound bite is this: The Federal Reserve cannot control the cost-of-living. This is REAL, and as such, it is influenced by real factors that are outside of the Fed's control, like oil, droughts, acts of war, and such. Inflation is a monetary phenomenon that, in the end, leaves ones cost-of-living unchanged.
I think it entirely possible that assets can provide a leading signal of a generalized, monetary inflation. But admittedly, this is mostly an article of faith and not science--the statistical link between these cost-of-living measures and asset prices is very tenuous. And economists have not been able to map the link that leads from excess money growth to a generalized inflation. So until that day, I think one who ignores asset prices when looking for signs of rising inflation does so at some peril.
So I would tend to take these rising housing price movements seriously and judge them along with a host of other asset measures when thinking about Fed policy. But of course, now we are a long way from the thread of this discussion: is the CPI mismeasured because of the rental approach? I say no--well, not in the way suggested by at Angry Bear.
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