The perverse logic of the CPI

After reading a short report in Businessweek regarding the impact of housing rental costs on the consumer price index (CPI), memories of previous work came flashing back.

For background material, see:

• Home ownership costs and core inflation
• Housing costs - core CPI recap

It appears that little has changed in what is the continuing perverse logic of the CPI that finds at least one economist counting on higher rental vacancy rates and the resulting lower rental costs to make "inflation" go lower.

Housing Provides Some Inflation Relief
Inflation pressures remained stubbornly high in March. But a let-up could be coming soon. Fallout from the housing recession looks set to put a lid on what have been rapidly rising rental and housing costs.

The consumer price index, less food and energy, was up 2.5% from a year ago in March. A lot of the upward pressure in core inflation has come from rents, up 4.6% on a yearly basis. Rent data are also used by the Bureau of Labor Statistics as an input to calculate homeowners' cost of shelter, referred to as "owner's equivalent rent." This price index rose 4.1% from a year ago.

But shelter costs should settle down soon. Looking at vacancy rates and shelter costs in 24 cities used by the BLS to calculate inflation, Goldman Sachs (GS) economist Seamus Smyth found that shelter inflation eased when vacancy rates rose above the long-term average. "These empty housing units are essentially excess supply on the market" Smyth writes in a research note to clients.

Vacancy rates are currently quite high. In the last quarter of 2006, the homeowner vacancy rate hit a record 2.7%, while the rate among rentals was 9.8%, vs. a 7.1% historical average.

Further downward pressure on rent costs is likely. According to the National Association of Realtors, new multifamily homes are still being added in some saturated markets, such as Philadelphia and Atlanta. What's more, many condominiums are being converted into rental units.

As increased supply holds down rents, it will also lead to a slowdown in homeowners' shelter costs. That would have a real impact as owners' equivalent rent accounts for nearly 31% of core CPI and rents almost 8%.

Lower shelter inflation could also play a role in monetary policy. The Federal Reserve's preferred inflation measure, the core personal consumption expenditures price index, also uses owners' equivalent rent, although it is given less weight. If the economy were to weaken further, lower core inflation would remove a big hurdle to cutting interest rates.

Taken to its logical extreme, if the government really wanted to make sure that "inflation" stays under control, it ought to just start building rental housing and leasing the units at below market rates. Real rental costs and the estimate used to judge the cost of owning a home via owners' equivalent rent contribute roughly 40 percent to the core rate of inflation (excluding food and energy), which is all anyone seems to care about anymore.

They'd have a good portion of inflation whipped and then the Fed could get about doing what they do best - cutting interest rates.

This is what the year-over-year costs of renting have looked like for the last ten years. You can see the relationship between the recent housing mania and the increases that landlords have been able to get from their tenants.


When housing started to boom back in 2002, more renters turned into homeowners and the decreased demand helped to push rental costs down. In 2006, when homeowners began realizing they really couldn't afford the toxic loans they had signed up for hoping they were soon going to be rich, homeowners turned back into renters and this increased demand helped to push rental costs back up.

With such a big weighting in the CPI, these trends have had a huge impact on "inflation".

Of course using owners' equivalent rent as a measure of home ownership costs really is much simpler than trying to reflect real world costs.

How would you go about judging the real cost of homeownership when, in the same year, your adjustable rate mortgage pushes your monthly payment up 50 percent and the value of your house goes down by 10 percent?