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Should House Prices be in the CPI?

Summary:
The rapid rise in house prices has stirred up the old debate debate about how the BLS calculates housing’s contribution to the CPI. This is no small debate since the US housing market is essentially the economy, mortgage debt comprises 75% of all household debt AND shelter is 33% of the CPI. Some people claim that the existing methodology understates inflation and gives people a false impression of how much our living standards are being impacted. The BLS, on the other hand, argues that housing prices do not necessarily reflect the changes in consumer prices and living standards because they’re more reflective of “investment”. I am sympathetic to both sides of this discussion so let’s see if we can add some clarity to the debate. The history of this debate is a rather long one. Here’s a

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The rapid rise in house prices has stirred up the old debate debate about how the BLS calculates housing’s contribution to the CPI. This is no small debate since the US housing market is essentially the economy, mortgage debt comprises 75% of all household debt AND shelter is 33% of the CPI.

Some people claim that the existing methodology understates inflation and gives people a false impression of how much our living standards are being impacted. The BLS, on the other hand, argues that housing prices do not necessarily reflect the changes in consumer prices and living standards because they’re more reflective of “investment”. I am sympathetic to both sides of this discussion so let’s see if we can add some clarity to the debate.

The history of this debate is a rather long one. Here’s a short summary from the BLS:

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.¹

This is something that I’ve discussed in some detail in the past. The BLS views housing as a mostly “investment” item as opposed to a consumption item. So, for instance, when you consume a hot dog and have to replace it then the cost of replacement is a direct reflection on your well-being. A $1 hot dog that costs $2 one year later is a material change in living standards, all else equal, since the hot dog is an asset that you literally consume. A house is much more complex. When you buy a house for $100K and sell it for $200K the house is still there. The buyer actually has the physical asset AND you have the proceeds from the sale. We are not worse off in aggregate because, presumably, the market has efficiently revalued the asset higher because past investment is now perceived to be more valuable. If you pay rent you are essentially consuming the housing unit over the course of the month and the landlord is obtaining your monthly payment.

Of course, anyone who owns a house knows that it’s not that simple. You do basically consume your house over time. For instance, my home has appreciated substantially since I purchased it just 5 years ago and underwent a hellish remodel. At that time the cost of replacement was roughly $300 per square foot. But in the ensuing years the cost of replacement has increased to $400 per square foot. As my physical home falls apart over the years I will need to replace it. But the key point is that, as I replace these components the housing market is likely to revalue the total home value to account for this investment. So even though I am consuming my house over time I am very likely to recoup those costs.²

This is all related to the “asset price inflation” debate that many people discuss. But here’s the important point around this debate that may add some clarity:

The BLS is specifically trying to measure the instability of consumption prices. House price changes reflect cost of replacement to some degree, but also reflect revaluation of past investment. Including this measure in CPI would be similar to including stock prices even though stock prices largely reflect an improvement in our overall living standards and balance sheets.

The BLS is specifically NOT trying to measure the instability of investment prices. This does not mean that housing prices do not or cannot reflect instability of prices. After all, we know, following the housing b0om, that the housing market doesn’t always reflect “efficient” prices and could reflect a very unhealthy economic environment.

The bottom line is that the BLS is not trying to measure the instability of investment prices. They are specifically trying to measure the instability of consumption prices. Therefore, it is practical to leave house prices out of the CPI since it is specifically a consumption price index. But this doesn’t mean that housing prices do not or cannot reflect instability of economic prices. In fact, I am a long time proponent of the Federal Reserve using housing prices to assess the stability of the economy over time. So it’s better to view these price indices as different measures of economic stability/instability where house prices reflect the stability of investment and the CPI reflects the stability/instability ofShould House Prices be in the CPI? consumer prices.

¹ – The BLS does a really nice job explaining the many myths surrounding the CPI. It’s worth a read if you have some time. 

² – This is not entirely true in my case. For example, I discovered, during my remodel that I would be required to upgrade the septic system on our property. As a result of this I had to drill two 60′ pits in my yard and install a new 1500 gallon septic tank. This was, maybe the the shittiest thing I’ve ever done in my life. Although, I did get to drive a Bobcat for 7 days which was life changing. 

Cullen Roche
Former mail delivery boy turned multi-asset investment manager, author, Ironman & chicken farmer. Probably should have stayed with mail delivery....

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