Tim Duy: Misunderstanding the CPI

Tim Duy takes issue with David Leonhardt's discussion of inflation:

Misunderstanding the CPI, by Tim Duy: David Leonhardt at the New York Times purports to explain the CPI – but by the end of the article, I began to wonder if he really understands it himself. True, much of Leonhardt’s analysis is reasonably accurate, and is summed up by a quote from Stephen Cecchetti:

It’s about as accurate as anybody is going to get it.

Unfortunately, Leonhardt’s ardent defense of the CPI is spoiled by his attempt to explain that incoming numbers actually exaggerate inflation:

That said, there is one way in which the official numbers were clearly understating inflation. To track housing costs, the Consumer Price Index analyzes rents, not home prices. (Why? Long story.) And rents didn’t go up anywhere near as much as house prices during the real estate boom. So the index missed the huge run-up in home values that made life harder on anyone trying to buy a first home.

The CPI is a measure of the average price level. Unless you just happen to be the average consumer, your personal CPI will be different, and possibly very different, from the headline numbers. But Leonhardt uses a specific consumer – a first time homebuyer – to justify his claim that using rents, not prices, to measure housing costs understated inflation during the housing bubble. Let’s take a different consumer. Me, for example. My mortgage payment has not changed in 5 years. Assuming I stay in my current house, my mortgage payment will not change for the next 25 years. All else equal, CPI was overstating inflation during the bubble according to my personal experience, and, unless rents fall or I move, will continue to overstate inflation.

Leonhardt extends a faulty analysis further to claim that the CPI will now be overstating inflation since it does not capture falling home prices:

Since 2006, of course, home prices have been falling. But rents have kept rising slowly, which means that, as far as the Consumer Price Index is concerned, housing has somehow gotten more expensive during the real estate crash.

So when the new inflation numbers come out next week, they will indeed be misleading. They will be artificially high.

Inflation may appear overstated to the first time homeowner, but what about the renter? If rents go up even while housing prices go down, how is inflation overstated from their point of view? Again, one cannot use a specific consumer to claim the CPI will be overstating inflation. Either Leonhardt doesn’t really understand inflation, or he is deliberately mischaracterizing inflation to dismiss incoming data as flawed.

Moreover, by dismissing as a “(l)ong story” the issue of why the BLS uses rents, not house prices, to measure housing costs, Leonhardt is missing an opportunity to explain the justification for the use of owner’s equivalent rent (OER). Alternatively, he just doesn’t want to explain OER because the explanation undermines his criticism of the CPI.

The CPI is a measure of the market basket of goods and services consumed by the average consumer. The service the consumer receives from housing is the shelter it provides. If a household can rent their home for $1,000 a month, then that is the price of the service component of their housing. Whatever mortgage amount the homeowner is paying above that $1,000 represents something other than a housing service. From the BLS – the “(l)ong story”:

Until the early 1980s, the CPI used what is called the asset price method to measure the change in the costs of owner-occupied housing. The asset price method treats the purchase of an asset, such as a house, as it does the purchase of any consumer good. Because the asset price method can lead to inappropriate results for goods that are purchased largely for investment reasons, the CPI implemented the rental equivalence approach to measuring price change for owner-occupied housing.

Increasingly, society views the purchase of a home as primarily an investment, not for the service it provides (don’t even get me started on this topic). The investment motive is justification for the wide discrepancy in many locals between house prices and rents. If my house rents for $1,000 a month, why would I pay $2,000 a month unless I saw it as an investment?

The BLS is properly trying to separate the shelter and investment components of housing; only the former is properly included in a measure of consumer prices (there is, however, a separate issue of measurement error). The investment component should be excluded, the same way we exclude the price of gold or a share of GE stock from the consumer price index. By criticizing the use of owner’s equivalent rent to claim that inflation is over- or understated, Leonhardt reveals that he really doesn’t understand the purpose of the CPI. It is a measure of consumer prices, not asset prices. Perhaps he can be forgiven; it is, after all, a “(l)ong story.”

Moreover, the debate over the use of OER in the CPI is something of a false debate. In my opinion, it misses the point entirely. The debate is not whether housing costs are miscalculated in the CPI – the BLS’s basic methodology is appropriate to achieve their objective. The debate is whether or not the Fed should include assets prices, such as home prices, in their policy objective of price stability. Just because there is a valid argument that the Fed should be using a measure other than (or in addition to) consumer prices does not imply that the CPI is flawed. It implies that the construction of monetary policy is flawed. In effect, the BLS is unfairly criticized for the Fed’s policy error.