First, I want to credit Stirling Newberry and the author of
The Big Picture economics blog. Their writings on this topic have been very helpful. Last week, the Bureau of Labor Statistics reported a higher than predicted inflation report. This sent the markets lower for most of last week. While it appears that Wall Street finally got the idea there is inflation in the US economy, the fact is the method of calculating inflation is low for several important reasons.
Although the US economy has had a housing bubble for the last few years, the official inflation figures do not count housing prices.
Here is a
short history:
Until 1983, the bureau measured housing inflation by looking at what it cost to buy and own homes, considering factors like house prices, mortgage interest costs and property taxes. But given the shifts in interest rates and housing prices, those measures could show big bounces from month to month. Besides, homes are a strange hybrid of a consumable good and a long-term investment. As part of a long-running evaluation, the bureau wanted to "separate out the investment component from the consumption component" of the housing market, said Patrick C. Jackman, an economist at the bureau.
In other words, a home isn't just where you hang your hat or an investment in the future (or, in the case of visitors to CondoFlip.com, for two days). It's something that is consumed, the way potato chips, gasoline or a barber's skills are. So the bureau decided to track a measure that represents only the consumption of housing: rent. And rents had much to recommend themselves as a long-term inflationary yardstick - they don't jump significantly from month to month - and as a proxy for home prices. Over time, after all, rents correlated very closely to home prices.
First, there is nothing inherently flawed with the BLS' logic. They decided to measure individual's consumption of housing, determining this was the best measure of the actual price of housing. However, this thinking runs into a problem in the current economy:
First, rent and home prices have become decoupled over the last several years, as Richard J. Rosen, an economist who is an adviser to the Chicago Federal Reserve, has observed. In the last 12 months, owners' equivalent rent has risen only by 2.3 percent, while housing prices have risen by a much larger amount.
The problem with using equivalent rent in the current economic environment is rental vacancies are near al all time high. For the US, national rental vacancy rates for 2001-2004 were 9%, 8.9%, 9.8% and 10.2%, respectively. In 2005 the average vacancy rate for the largest 75 metropolitan areas was 9.7% -- off the 2004 high, but still high by historical standards. Here is the problem for the official inflation number: high rental vacancies mean there is more supply than demand. Therefore, rental rates are depressed. As a result, the official inflation number understates the actual level of inflation.
In addition, Owner's Equivalent Rent is a more appropriate measure for an economy that is consuming housing, rather than investing in housing. The current real estate bubble is clearly more of an investing environment.
Here's the final problem:
It turns out that rental prices account for 30% of the core CPI. As we saw last month, this was zero flat.
So, a full 30% of the official inflation number is abnormally low.
It's not as though the people who make policy decisions are unaware of this problem. The Federal Reserve commissioned a study on it and determined:
"Downward pressure on rental prices mainly resulted from an increase in demand for homeownership, which was spurred by historically low mortgage interest rates (see Figure 19). As housing starts and home sales surged in the recent recession and recovery, the national rental vacancy rate jumped from 7.8 percent in the fourth quarter of 2000 to 10.2 percent in the fourth quarter of 2003. This effect was compounded by the way owner-occupied housing prices are measured in the CPI. The CPI uses a rental-equivalence approach, measuring the value of the shelter services an owner receives from his or her home. Price movements in owners' equivalent rent reflect changes in prices of rental units that are comparable in characteristics to owner-occupied homes. Therefore, increased demand for homeownership put downward pressure not only on tenants' rent but also on owners' equivalent rent -- the largest component in the CPI."
While I don't know what the official inflation number would be with the actual prices of houses included, it is obviously higher than currently reported.
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