Evan Soltas
Jun 21, 2012

No Price Like Home

The Federal Reserve, along with most other central banks, including the Bank of England and the European Central Bank, have been mis-measuring inflation for years. And there's a compelling case that their mis-measurement led, albeit indirectly, to the housing boom and bust, and therefore to the 2008 recession.

I say mis-measured, but in reality, economists have only a vague idea of what they're talking about when they talk about the "price level" is and how it has changed -- price inflation. In fact, how to measure prices has for much of the modern history of economics been a prime subject of debate.

The economics field has produced more measures of macroeconomic price inflation, as a result, than I know or will count here. Just for starters, you've got the Consumer Price Index (headline and core), the Personal Consumption Expenditures price index (headline, core, trim-mean), the GDP deflator, etc. They all appear in different areas: CPI is often used for adjusting wages for cost-of-living, the Fed targets the headline PCE price index at 2.0 percent year-over-year, the GDP deflator is used in national accounts calculations.

Most of them, however, do a frankly poor job of measuring a very important component of prices: housing. You might say, in fact, that there's "no price like home" if you want to understand how monetary policy got it so wrong in the 2008 recession.

With the exception of the GDP deflator, the CPI and the PCE all use a measure of housing prices called "owners' equivalent rent," or OER. What OER basically entails is the Bureau of Labor Statistics (BLS) asks homeowners for their own assessment as to the potential rental price of their own home -- and as a result, what OER has failed to count has been the asset-price inflation of housing.

Housing asset-price inflation had been included in the CPI until 1983, in fact, when the BLS introduced OER because asset prices "can lead to inappropriate results for goods that are purchased largely for investment reasons." The reason to count housing prices via assets and not via OER, however, is pretty straightforward: houses are not just a financial investment, they are also a consumer cost. Analogously,  the CPI counts cars by their asset prices if they are new or used, and by the costs of leasing when they are leased. Today, I find it fair to flip the Fed's 1983 statement on its head, and say that OER "can lead to inappropriate results for goods that are purchased partially as a consumer durable good." (Mike Shedlock, a.k.a. Mish, agrees with me.)

Replacing OER with a measure of housing asset prices, the Case-Shiller 10-City Home Price Index, in the headline and core CPIs, we get the following data:Let's call this measurement CPI-H, for "housing." I've made my datasets available here (headline CPI-H) and here (core CPI-H) on FRED, and they will forever update themselves, so bookmark this page or something.

You'll notice that CPI-H is substantially different from the regular CPI numbers, with inflation running higher in the 2000s, a sharper deflation in the 2008 recession, and weaker inflation since then. The contrast emerges because OER was such a large component of the headline and core CPI numbers: as of the December 2010 weighting, it was 24.9 percent of headline, 32.3 percent of core.

I bring this up, in part, because there's been movement by the Office for National Statistics in the UK to replace their CPI and RPI, or Retail Prices Index, with a CPIH, which would include some OER and some mortgage payment costs. (The mortgage payment component is a proxy for asset prices.) At the same time, Eurostat, which compiles the HICP inflation numbers for the Eurozone, is considering a new approach to owner-occupied housing.

Both the Bank of England and the European Central Bank have figured out that they are mis-measuring housing; it's time for the Fed and the Bureau of Labor Statistics to introduce a CPI-H. In the meantime, you're free to use mine.