Maybe economic theory is wrong

In looking up some data for the previous post on initial jobless claims, this little FAQ about the Consumer Price Index was stumbled upon at the Labor Department. It doesn't say how long it's been there, but it was apparently updated today.

Here's the part that explains the rationale for owners' equivalent rent being included in the inflation statistics in lieu of anything having to do with actual home prices.

The CPI used to include the value of a house in calculating inflation and now they use an estimate of what each house would rent for -- doesn't this switch simply lower the official inflation rate?

No. Until 1983, the CPI measure of homeowner cost was based largely on house prices. The long-recognized flaw of that approach was that owner-occupied housing combines both consumption and investment elements, and the CPI is designed to exclude investment items. The approach now used in the CPI, called rental equivalence, measures the value of shelter to owner-occupants as the amount they forgo by not renting out their homes.

The rental equivalence approach is grounded in economic theory, receives broad support from academic economists and each of the prominent panels, and agencies that have reviewed the CPI, and is the most commonly used method by countries in the Organization for Economic Cooperation and Development (OECD). Critics often assume that the BLS adopted rental equivalence in order to lower the measured rate of inflation. It is certainly true that an index based on home prices would be more volatile, and might move differently from other CPI indexes over any given time period. However, when it was first introduced, rental equivalence actually increased the rate of change of the CPI shelter index, and in the long run there is no evidence that the CPI method yields lower inflation rates than some other alternatives. For example, according to the National Association of Realtors, between 1983 and 2007 the monthly principal and interest payment required to purchase a median-priced existing home in the United States rose by 79 percent, much less than the rental equivalence increase of 140 percent over that same period.

The approach is grounded in economic theory that may be looked back upon someday as one of the greatest blunders in the history of economics - kind of like like after the Great Depression when Austrian Economics, popular at the time, was discredited for the rest of the century.

And that last part about the National Association of Realtors - that probably needs a little looking into. Something smells awfully fishy about that conclusion.

Also see: The complete and utter failure of owners' equivalent rent

------------------------------------------------

UPDATE - Sept 4th, 10 PM PST

I was going to put this in the comments section but figured it would be better here...

I verified that OER from 1983 to 2007 has risen 140 percent.

The January 1983 median home price was $73.5K which, with a 90% LTV 30-year fixed loan at 13.25% works out to a PITI of $745 per month.

The January 2007 median home price was $254.4K which, with a 90% LTV 30-year fixed loan at 6.22% works out to a PITI of $1405 per month.

This works out to an increase of about 90 percent, which is close enough to the 79 percent figure cited by the BLS, so there's no need to call them.

This is more a story of interest rates than it is anything else and what's much, much more important than the last 25 years is the last ten years or so. It could be that OER worked well for the first ten years or so until we got "innovative" financing in the last decade. For example, a quick check shows OER increased 29 percent from 1997 to 2007 but mortgage payments increased by about twice that amount.

I'll do a follow up on this sometime soon. As long as the BLS and NAR brought this up and seemed to poo-poo the whole idea of a flawed OER, I'm now curious to see how PITI versus OER looks like over time - my guess is that you'll see a big disconnect between the two once interest rates leveled out in the late 1990s and home prices took off.

Sources:
Census Bureau Home Prices (.pdf)
Federal Reserve Interest Rates