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Maybe economic theory is wrong

Thursday, September 04, 2008

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

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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

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7 comments:

little larry sellers said...

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

That figure doesn't seem remotely possible. You would think the NAR would at least concoct something believable, but I can't really blame them for reaching. At this point, anyone who still looks at the NAR as a legitimate authority on housing data would probably swallow anything.

Tim said...

I'm going to call the BLS tomorrow to get the source data for that claim. In this post from 2005 - Home Ownership Costs and Core Inflation - OER and the OFHEO home price index are on the same chart going back to the 1970s and it's clear to see that it's not home prices. It must be the difference in mortgage interest rates which were about 14 percent at the time.

Bruno said...

Why was Austrian economics discredited after the great depresssion? And why just through the end of the century?

Tim said...

See the update now included in the original post re: OER versus mortgage payments - very interesting stuff.

Austrian-style economics was blamed for the length and severity of the Great Depression where credit excesses were left to work themselves out on their own.

Why just through the end of the century? Because now people are realizing that you can't just expand money and credit endlessly to solve all economic ills.

Anonymous said...

There's a little bit of hair-shirt in every good central banker. Paul Volker was lauded after turning the basket-case economy around in the early 1980's.

Actually it's not just the US that has had it's measure of inflation (CPI) hobbled. The Reserve Bank of Australia changed the CPI measure of housing in 1998 to include only the cost of "new" housing... thus removing any measure of the inflation of "land" values. Australia has seen large increases in land values in the last decade.

The justification (by the RBA) for this shift was to reduce the "feedback" effect that measuring the costs of loans has on the cost of the loans... if that makes sense? Subsequently the level of private debt has skyrocketed in Australia, and in the last 7 years household savings have become negative. It's how to have a boom, without it showing up in inflation.

The conservatives here like to push the line that interest rates are always lower when they're in power. But as you can see, it all depends on how you measure inflation. Mind you, they've just been tipped out of office after running with that line for the last few election cycles.

eternitus said...

Mortgage Rates were 15% in 1983... just about the highest ever... and housing affordability was at an all time low. That period was an anomaly and should be by no means used as a benchmark for "affordability."

That's a complete joke.

Anonymous said...

Portfolio.com
Rent vs Buy Datapoint of the Day
Friday September 5, 5:03 am ET


How do we know we're in a housing bubble? One way of knowing is by looking at house prices, which during the bubble were rising much more quickly than rents. That was clearly unsustainable. But today, in a CPI FAQ, the BLS uncovers a startling statistic:

ADVERTISEMENT


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.

Now I'm not one to pay overmuch attention to the NAR, they're an advocacy group more than a source of reliable statistics. But I do actually believe this, because if you look closely they're not saying that rents have risen more than prices. Instead, they're saying that rents have risen more than the cost of buying a house, which is different, and which is largely a function of falling mortgage rates over the past 25 years.

All the same, for rent-vs-buy calculations, it's precisely the mortgage payments that you'll want to be looking at. And according to this, in order to get back to the ratios of the early 1980s, house prices would have to almost double from their 2007 levels, with rents not moving at all.

Which does raise the obvious question: why on earth was anybody buying a house in 1983?

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