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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.

July 13, 2005 in Housing, Inflation | Permalink

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Thank you very much for this analysis.

Posted by: Dave Schuler | July 13, 2005 at 04:15 PM

The big question I wonder how the CPI data distorts comparisons of living standards over time.

If my son now buy a house comparable to one I bought 25 years ago the costs of his house compared to my house is going to be much larger then the CPI suggest.

so does this mean that over a long period the biases in the cpi measure of housing means that it biases the standard of living my son experiences at age 30 vompared to the standard of living I had at age 30?

Posted by: spencer | July 13, 2005 at 04:40 PM

The big question I wonder about is how the CPI data distorts comparisons of living standards over time.

If my son now buy a house comparable to one I bought 25 years ago the costs of his house compared to my house is going to be much larger then the CPI suggest.

so does this mean that over a long period the biases in the cpi measure of housing means that it biases the standard of living my son experiences at age 30 compared to the standard of living I had at age 30?

Posted by: spencer | July 13, 2005 at 04:42 PM

Ricardo Reis has a paper on 'dynamic price indices' in which he manages to get asset prices into the price index and finds that they give a very different picture of inflation in the post-WWII US. The difference seems imense. If this makes sense it's a big idea, but I cannot tell yet...getting asset prices (as proxies for expected returns?) into the price index may make sense for durables that need to be financed, and for accounting for the changes in one's life cycle budget constraint.

http://www.econ.princeton.edu/seminars/Summer_Seminars/dpi22.pdf

Posted by: Stefan | July 13, 2005 at 07:09 PM

Sorry, but I think that measuring & monitoring inflation is TOO important a subject to deal with so topically. First, your opinion that "The idea of the CPI is to measure, as closely as possible, the average person's cost-of-living" makes for a great soundbyte, but I'd guess more than a few Economists might argue that wasn't even the CPI's initial purpose. Now, almost 90 years later, because so many payouts are tied to the CPI, it seems an especially tough to ask us to believe that too many politicians (with their own spending priorities) haven't purposefully adjusted this statistic downward.
On housing's role in the CPI - I understand almost 68% of U.S. families own their own homes (most with their lenders). That's a very large number, so before I'd accept that a rental equivalence approach is the "right" one to measure the true cost of a home, I'd like to hear how that data input is collected. If homeowners are called up & asked how much they'd rent their homes for, I'd argue most wouldn't have a clue. Even if they said they did, I'd dismiss their answers as conjecture & valueless - until they actually "do" it. And, when they do it, the numbers speak for themselves.
We're in the 21st Century, there's lots of "real" information out there to use to measure inflation & or the CPI.

Posted by: bailey | July 13, 2005 at 08:05 PM

The question of whether the CPI is a "good" inflation measure depends entirely on the question you are asking. And with the CPI it is clear that it is used precisely to measure the cost of living - That is explicitly why so many COLA's are linked to it - COLA = "Cost of Living Adjustment". So, there is a real problem if, as the post says, only 32% of the people rent and the data show that rental costs diverge significantly from costs of ownership. I am not one who is in favor of including asset prices in the CPI - they are important and policy makers should obviously track them but they have nothing to do with out-of-pocket living expenses that are supposed to be tracked by the CPI.

It is obvious why rental equivalents are used for housing but when actual out-of-pocket costs differ from this we need to take a look, and it DOESNT MATTER WHAT THE SOURCE OF THE DIVERGENCE IS if the goal is to measure out of pocket expenses. Some people take a purist view that simply because the rise in ownership costs derives from an asset price increase then it is illegitimate to include it in the CPI. My point is, it doesnt matter if the cost increase comes from space aliens - the ONLY criterion should be whether or not we are accurately measuring the actual out-of-pocket expenses of the average household unit. If we arent doing that then we should look for ways to do it better. Some weighted average of costs of rental and ACTUAL costs of ownership would seem appropriate. The costs of ownership could themselves be weighted according to the percentage who have actually bought new houses for their primary residence during the period and the costs of those who continue to live in houses they own. These costs themselves are variable as anyone who has an ARM can tell you.

In summary, the CPI is used as a measure of out-of-pocket expenses. We can do better than we are now doing if we know for a fact that the majority of the people dont rent and that rental costs are an inaccurate reflection of what they actually have to spend.

Posted by: steve kyle | July 14, 2005 at 04:55 AM

BRAVO, Steve Kyle!!! "... the ONLY criterion should be whether or not we are accurately measuring the actual out-of-pocket expenses of the average household unit. If we arent doing that then we should look for ways to do it better."
But, every time Washington attempts "to do it better", politics gets in the way. I don't know how many times or how often the CPI has been adjusted, but I don't believe it's ever been adjusted upward. The Boskin Commission's "hedonics" adjustment appears to be more political hocus-pocus than Economic reasoning. I recall K. Abraham (BLS head @ the time), in her response, saying something to the effect: Yes, it can be argued the CPI is a point too high, but it can also be argued it's a point too low. My guess is we'd all be a lot better off today if we addressed our inflationary circumstance & prospects WITHOUT that last point adjustment downward. At the very least, the housing anomaly wouldn't have nearly the same significance as it does today. I think it's time for the Economics Community to initiate a Global conference to standardize the indicators we've all become so dependent upon. Thanks for your great i/p.

Posted by: bailey | July 14, 2005 at 10:44 AM

David: Thanks for passing on these very helpful comments -- it's good to get input from someone who really knows a lot more about this than I do.

I agree completely that the rental equivalent approach is probably the right one for the CPI to follow (as I tried to make clear in my post). However, I think it's still worth thinking about the difference between individuals' actual out-of-pocket expenses for a given basket of goods, and what they could have spent if they had made different choices (i.e. to rent instead of buy). Put another way: a lot of people complain to me that their cost of living has been rising a lot lately due to housing costs, and I think we need to think about why their experiences may differ from what the CPI tells us.

Also, reading Mike Bryan's thoughts raises another question for me. Perhaps it makes sense to think of buying a house as really a combination of several purchases: rental-equivalent housing services; the purchase of an asset (analytically equivalent to the purchase of stocks, as Bryan suggested); and the purchase of some less tangible "ownership benefit", i.e. the benefit due to personal preferences that one might reap from owning versus renting.

Clearly we don't want to include the asset investment portion of a home purchase in a cost-of-living measure. But mightn't it make sense (theoretically) to try to gauge how expensive that intangible benefit from owning versus renting is? I guess I have a sense that the premium that one might pay to own versus rent has risen recently, and that's the portion of the inflation in housing that arguably should be included in a cost-of-living measure but which the CPI does not include. (Clearly it would be very difficult, if not impossible, to actually measure this component of the rise in housing costs.)

One last note: I agree completely with Bryan's statement that we have to take into account the fact that people who haven't bought a new house in the past few years have not experienced this housing inflation. But I disagree that the fraction of the US population that has bought a new house recently, and thus faced steep inflation in housing costs, is "quite small". Given that close to 50% of people in the US move during any five-year period, the portion of the population that has faced house price inflation above that measured by the CPI in recent years could well be in the neighborhood of 20-30%. No, that's not everyone, but it is a significant number.

Thanks again to you and Mike Bryan for your thoughts about this.

Posted by: Kash Mansori | July 14, 2005 at 01:10 PM

Kash, Don't forget maintenance costs of home ownership. re: "... it makes sense to think of buying a house as really a combination of several purchases: rental-equivalent housing services; the purchase of an asset (analytically equivalent to the purchase of stocks, as Bryan suggested); and the purchase of some less tangible "ownership benefit", i.e. the benefit due to personal preferences that one might reap from owning versus renting."
Depending on home's age, it's not unreasonable to expect to pay 1% or more of mkt. value per year just to keep the aging house from LOSING value.

Posted by: bailey | July 14, 2005 at 01:33 PM

David: You say, "...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."

Have you dealt with this topic in your blogging or other writing? Many are keenly interested and wonder why the European Central Bank is now exploring ways to incorporate this better into their policy-making while the US Fed seems disinterested. Or maybe I've not been following the issue closely enough to see where the US Fed is attending to it.

Perchance you can point us to where the US Fed now stands on the matter and who among your colleagues are suggesting, as you have here, that "asset price inflation/deflation" ought not to be ignored in inflation related policy-making.

Posted by: Dave Iverson | July 14, 2005 at 01:42 PM

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