Wednesday, June 17, 2009

Why the CPI Chronically Understates Housing Deflation After a Boom

The Consumer Price Index is out today and is reported to show prices down 1.3% yr on yr, the largest drop since 1950. However, this index understates the drop in prices. Here is a link to the Bureau of Labor Statistics description of how it estimates housing costs in the CPI:

This total is 30.4% of all costs. There is one fundamental flaw, which is conceptual. 24.4% of the entire CPI is supposedly from what a homeowner would pay to rent the home he/she lives in. The problem is that this cost is theoretical, imaginary and unvalidatable. What is validatable is what the house is worth as an asset, what the mortgage would be on the house, what the taxes and other expenses of maintaining the home are, etc.: in other words, what the cost of OWNING is. The idea that an owner would in effect rent to himself and that that guesstimated cost is part of the cost of living is strange.

The practical problem stemming from this technique is that the owner is asked what his house is worth as a rental unit. Well, most people are going to overestimate the value, and in truth most people who own their own home live in communities without well-developed home rental markets, and often the rental homes are not as well-maintained as the owned homes, so who knows what the rent would be? Further, if all owners rented their homes out, there would be more supply, and rents would then drop.

The beancounters at BLS insist that rents are rising and that "owner-equivalent rent" (that 24.4% of the CPI) has risen over the past year and rose last month.

In other words, the CPI probably understated housing inflation somewhat during the housing boom, but because of the technique of owner-equivalent rent, most homeowners were probably generous in their estimate of OER increases. However, most homeowners are loathe to acknowledge that their home is declining in price, and so they are understating the OER decline. Numerous studies show that people will agree that the housing market is in a decline locally, but believe that their individual house price is resisting that tide. That's human nature, apparently.

Thus, 24.4% of the CPI is, most importantly, an inappropriate measure of inflation, but we can't change that.

What we can do is realize that within the confines of using owner's-equivalent rent as a measure of price changes to live in a home, there is likely a systematic bias for the CPI to keep up with price increases in a housing boom but to lag price decreases in a housing bust.

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