Housing and Inflation Metrics

2024 09 12

Kevin Erdman has two posts in one, both good.  The first, how we can know that land use restrictions and building codes that restrict housing construction are responsible for increases in the cost of housing, is important and well argued.  But it is the second, the one announced in the title, Rents shouldn’t influence monetary policy, that I want to address here

I think the way to argue about how to measure inflation for monetary policy purposes is to think about why a central bank should be trying to achieve an inflation target. 

Ultimately the reason for a central bank to choose one inflation rate over another is to facilitate markets clearing.  When economics happens, 😊 when preferences or technology change (an important change in import or export prices acts like a change in technology), relative prices need to change, too.  If some prices cannot easily change downward, other must change upward for relative prices to change.  If there can be no change in relative prices some markets cannot not clear, resources (and not _just_ labor) become unemployed and real income declines.  A central bank that can facilitate the adjustment, allow some prices to rise when others do not, therefore, maximizes real income. 

Within this framework, the problem with Owner’s Equivalent Rent (OER), which is part of both the Consumer Price Index (CPI) produced by the Department of Labor Bureau of Labor Statistics and (a smaller part of) the Personal Consumer Expenditure Index (PCE) produced by the Department of Commerce Bureau of Economic Analysis, is that it is not a price that can or needs to adjust to facilitate the clearance of a market.  Indeed, it is not really a price at all.  It is a _deflator_ for the imputed nominal value of the services from owner occupied residences. It is relevant for estimating real GDP but its movement does not affect real income.  Consequently, it has no place in the metric of inflation that a real income-maximizing central bank should seek to manipulate.  As a matter of fact, the European Central Bank, although for administrative reasons, targets an index, the Harmonized Index of Consumer Prices (HICP), that does not include owner occupied housing.

If the OER tracked other price indices no harm would be done, but it does not. It is a slow-moving average and so reduces CPI and PCE when other sub-indices are rising and raises it when other subindices fall.  This is seen clearly by comparing CPI and the PCE with the HICP by BLS which uses the European Central Bank methodology and excludes OER.

The PCE which the Fed targets is less affected by OER than the CPI, but it may still have an outsized effect on Fed policy. In the run up of inflation in 2021-22, The Fed did not begin tightening in September 2021 when TIPS first exceeded target but in March 2022 when YOY HICP was already 0ver 9% and PCE was less than 6%.  By the same token HIPC had fallen into the 2% range from June 2023 when PCE was still over 3%.  Having its eye on the wrong ball may be contributing to the reluctance of the Fed to dial back the EFFR from the maximum it has been at since mid-2023

[Other reasons are discussed here: https://thomaslhutcheson.substack.com/p/improving-fed-decisions

[Standard bleg:  Although my style is know-it-all-ism, I do sometime entertain the thought that, here and there, I might be mistaken on some minor detail.  I would welcome comments on these views.]

No image because Substack only offers the option of uploading animge fom a mobile device.