The Complete Failure of Owners' Equivalent Rent

by: Tim Iacono August 15, 2008    

Tim Iacono

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It has been noted here on many occasions previously that future historians will have a field day when assessing economic activity during the last few decades. Nowhere will the puzzlement be more profound than when they turn to the measure of home ownership costs in the government's inflation statistics - owners' equivalent rent.

As shown above, there is nothing "equivalent" about the price of housing and how home ownership costs are represented in the consumer price index.

For those not familiar with the history, it can be summarized as follows:

In 1983, after an era of soaring inflation and the biggest housing boom and bust since World War II, estimated rental costs were substituted for such sensible measures like mortgage payments, taxes, and insurance in the "official" government measure of inflation.

Since then, the rising cost of home ownership has been barely noticeable in the cost of living (at least the way the government measures it), much to the benefit of the pencil pushers in Washington who are rewarded with lower cost increases for payments indexed to consumer prices - little things like social security.

None of this mattered much until after the internet bubble went bust and the Greenspan Fed started looking for a new bubble to inflate. Fast forward to today and it's clear to see how distorted the reporting of consumer prices became in the new decade.

Substituting the Case-Shiller Home Price Index for owners' equivalent rent shows the following divergent measures of inflation, where the "pedal to the metal" one or two percent short-term rates from 2002 to early-2005 look, ahem, "inappropriate" at best.

Even more surprising, when factoring in today's plunging home prices, the annual rate of inflation, reported at a 17-year high of 5.7 percent yesterday, recently dipped into negative territory and currently stands at less than one percent.

But it gets even better...

Since much of headline inflation comes from food and energy, stripping those out of the most recent inflation data and substituting the Case-Shiller Home Price Index for owners' equivalent rent shows core inflation, economists' favored measure of inflation, now at about minus 4 percent.

Since OER accounts for almost one-third of core inflation, it has a much bigger impact than for overall inflation as shown clearly above - both at the height of the housing bubble in 2004-2005 and now as the housing bubble has gone bust in 2007-2008.

When including soaring home prices instead of the tumbling cost of rent in 2003 (back when anyone and everyone was buying houses with no money down, bidding home prices skyward while pulling the rug out from under the rental market), core inflation would have measured more than four percent, not the one percent reading that is now characterized as the "2003 deflation scare" among dismal scientists.

The historians will not be kind when they pass judgment on current day economists.

Notes:

1. The charts above use a simple substitution of the Case-Shiller Home Price Index for owners' equivalent rent and are not intended to duplicate the pre-1983 measure of home ownership costs calculated by the Bureau of Labor Statistics.

2. The first chart above was featured in Kevin Phillips' recent book Bad Money (highly recommended reading) as discussed here previously.

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This article has 8 comments:

  •  
    Aug 15 09:56 AM
    I have lived in & owned the same house for the last seven years. I fail to see how the gyrations of the Case-Schiller index had any impact on my cost of living.

    Despite the press, the majority of households in the US did not buy a new house recently. The gyrations of home-prices, at the margin, are not a good indicator for the cost-of-living for the overall population.

    CPI is meant to measure the cost of living for the general population NOT 'the cost of living for those who happened to buy a house that year'.

    Get a clue.
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  •  
    Aug 15 01:36 PM
    Disstresse: The CPI measures a basket of good and services. Over 80,000 items are measured each month. I bet you didn't purchased a few of the 80,000 items that are in the Index. So which items should they drop?

    The CPI was never meant to be a personal inflation Index. The items make their way into the Index from Census Bureau surveys. These items are then placed in categories and weighted based on proportion of income spent on each category.

    So, I think the author and everyone else knows that the CPI is not our personal inflation indicator. I read this author a great deal and he on the government numbers like a blue tick hound. He is only showing how the published numbers are not reflecting the general inflation level that we experience. He does a wonderful, comprehensive job if you ask me.



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  •  
    Aug 15 02:56 PM
    its simple.the inflation rate of your basic 5 daily needs is app.15-16%. thats all most people are interested in. that figure does not take into account the shortage of weights & measures we experience every day at the store(mainly supermarket).all the rest is bs designed so federal employees & seniors dont get too big an increase.if you believe gov. figures i have a famous bridge in nyc i can sell you at a discount.
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  •  
    Aug 15 03:54 PM
    i agree with disstress. the current measure may not be perfect, but i think it makes even less sense to use home price changes instead.

    cosinder that the cost of shelter is typically the largest part of a consumer's budget, and thus by far the largest single component of the CPI. People "consume" shelter by either renting, owning their home outright, or financing by locking in a set monthly payment - and usually for periods of 5 to 30 years. And most people move infrequently. Thus, for the vast majority of people, the yearly change in actual home prices has zero affect on household budgets.

    And, since most owners finance the purchase of their home, then interest rates play a key role in determining the monthly "cost". If home prices are going up, but rates are going down (like happened a few years ago), then the monthly payment for new buyers might actually be lower year over year!

    I am not sure how the BLS actually calculates "owner's equivalent rent" - but considering that rent really is the true cost of shelter, it certainly seems like the better measure for the CPI.
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  •  
    Aug 15 05:01 PM
    "If home prices are going up, but rates are going down (like happened a few years ago), then the monthly payment for new buyers might actually be lower year over year! "

    This has proven not to be true. If it were true, I wouldn't be feeding homeless people in the soup kitchen today. The home price increase wiped out any savings from lower interest rates on average.

    It would be better if the CPI measured rents and home prices.
    Reply | Link to Comment
  •  
    Aug 15 06:05 PM
    Anybody who even tends to believe the US Government about inflation-personal or otherwise is a dumb goose or something. It's a total joke and the whole bunch of number crunchers should be fired forthwith.
    Reply | Link to Comment
  •  
    Aug 15 09:10 PM
    If the cpi was not supposed to be a personal cost (inflation) index, then why is so many retirement and other cost/payment adjustments tied to it. The cpi is the defacto measure of inflation on the consumer. This is not logical argument but simply fact.

    I do believe over the long haul the index is valid. In the short haul, however, the cpi is not measuring the distress on the consumer. We need a new short haul indicator which removes discressionary items and measures simply food, shelter, clothing and transport costs.
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  •  
    Aug 15 11:52 PM
    sorry hanson, i don't fully understand your reply. the point i was trying to make in regards to financing is that most people look at what monthly payment they can afford to determine how much house they can buy. as rates move higher, they can afford less house, and vice versa. in fact, this was ultimately one of the major drivers of the housing bubble. as rates were falling into 2003, the actual "affordability&qu... of housing was increasing in many parts of the country. as home prices continued higher and the bubble started inflating at full steam, people starting taking out risky mortgage products en-masse to keep payments "affordable"... this ultimately lead to the growing soup kitchen lines you now see.

    i think "the hand" hit the nail on the head - the CPI has short term limitations, but does a pretty good job of tracking price changes over the long run. And i don't think it's imperfections are born from some grand conspiracy to minimize federal wages or social security or the like. and i certainly don't think the BLS is as incompetent as many make them out to be. While the CPI is by no means perfect, no measure will or even could be - or we would most likely be using it...
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