U.S. Bureau of Labor Statistics Stated CPI Housing Cost Rationale

“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…  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.” 

Perspective

I can understand why “academic economists” would endorse “rental equivalence” as the CPI’s measure of housing costs.  This makes perfect sense… if you live in a vacuum and ignore cultural values, social pressures, personal preference, rights-of-passage, the influence of marketing, pride, ego, the benefits of stability, the irrationality of consumers and a control premium which each influence the value of owning a home in excess of rental equivalence. 

Based on historical consumer observation, renting an equivalent shelter is a vastly inferior substitute to ownership.  This behavioral reality is easily identified and ingrained in the cultural and social preferences of the U.S. population.  I wonder how many behavioral economists today would concur with the CPI’s rental equivalence voodoo adopted in 1983?

The CPI housing methodology is deeply flawed and a classic example of academic theory being completely disconnected from reality.

A (Really Exhaustive) Case as to Why the Non-Investment Value of Owning a Home is Not the Same as the Price of Equivalent Shelter  (feel free to skim down to Dismal Reality once you have found religion)

• The non-investment value of a home is related to the value of shelter but not equivalent to it.  There is an obvious premium placed on owning relative to renting completely distinct from investment value.  The rental equivalence metric ignores this reality.

• Less than 20% of American households have consciously chosen to make a financial investment in the stock market outside of an employee-sponsored plan.  Yet the Government proposes that 68% of this same pool of individuals have consciously chosen to invest in the financial asset component of a house.

• Not one in ten homeowners could describe the rental equivalent component of their home value or quantify its investment value component in real or percentage terms

• What percentage of real estate brokers could quantify what an individual house’s investment value component is?

• How many Americans since 1995 do you think calculated the relative value components of shelter and investment when deciding to purchase a home?

• What would a buyer who assigned no investment value to a house pay to purchase a home?  Such transactions happen every day and the buyers still pay market prices.  These people do so happily because they place a large premium on ownership relative to renting equivalent shelter.

In reality, the vast majority of owners do not buy or continue to retain ownership of their homes for any reason related to the CPI’s definition of investment value.

Personal Analogies  (Everybody's Got One)

I have spoken to a dozen people who bought homes from 2005 to 2007 and not one gave meaningful consideration to the investment component of the home’s value when making the decision to buy, and none viewed the potential for declining property values as a deterrent to the purchase. 

My parents have lived in their home for close to 40 years.  They didn’t consider selling the house when the price of the investment component rose to unsustainable levels during the Housing Bubble, and they are not considering selling it now that the investment value is falling.  They maintain ownership of the house because they like it, have lived there a long time, attach value to its familiarity, sentimentality, etc… 

The Housing Bubble and Ongoing Collapse Illustrates an Important Concept

Many Americans, especially in recent years, purchased housing out of the concern that unless they “got on the ladder” they would never be able to afford to buy.  These consumer actions were motivated by concern that “ownership” was becoming unaffordable, not that equivalent rent was rising or that houses had become more attractive investment opportunities

Many buyers during recent years have done so with the expectation that housing prices would likely decline and certainly not keep pace with inflation.  This decline is directly attributable to a decrease in investment value.  These buyers have been willing to “invest” in an asset they expect to lose value.  Why?  Because the value placed on owning far outstrips that of renting equivalent shelter. 

House prices are collapsing.  Homes are no longer considered to be a safe store of value.  The expectation is that house prices will continue to decline as foreclosures persist and unemployment rises.  Investors do not borrow large sums of money to make highly leveraged purchases of assets that are falling in value.  From an investment perspective such a strategy is disastrous.

So why do people continue to buy houses? 

Those purchasing homes are not doing so with the expectation of capturing outsized investment returns.  They are buying houses because the cost of ownership is lower than it has been in recent years.

A Crude Analogy

The CPI’s housing logic could be stretched to exclude gasoline prices from the CPI.  Oil is an investment as well as being a consumer product and a necessity of life for many.  The Government has made it clear that it believes that investment speculators manipulate gasoline prices to the detriment of consumers. 

The “public transportation equivalent” could be argued to be a replacement for gasoline prices in the CPI.  Surely no one would argue that riding the bus is the value equivalent to driving one’s car.  But the Government has been arguing since 1983 that renting comparable shelter is the value equivalent to owning a home.

Dismal Reality

Houses are consumer products.  In fact, they are used in this fashion to a far greater extent than a plethora of other similarly classified items.  People do not approach consumer purchases from the perspective of investors. 

The existence of a vastly inferior substitute to a consumer product does not constitute an equivalent measure of its value.

• The price of riding the bus is not a suitable substitute for the cost of a car or a gallon of gas
• The price of a bottle of water can not be replaced by the cost of public drinking fountains
• Buying a book is not the same as going to the library
• Rising health care costs can not be ignored because free-clinics exist

There is no doubt that including housing costs in the CPI did track some investment component of a consumer product.  But it was a far more relevant and useful metric than the current methodology.

What the Federal Government and Bureau of Labor Statistics fail to grasp is that the price of housing is made up of three components not two; the value of shelter, value as an investment and the premium placed on ownership above renting equivalent shelter. 

This premium varies on a case by case basis, is material, measurable and pervasive.  It may constitute the majority of a home’s value and in some cases totally displaces the investment component.  As such, rental equivalence is an entirely inadequate metric for quantifying the non-investment value component of a house’s price. 

By ignoring “the ownership premium” the Government is not accounting for a material price which influences the cost of living.  Given the high cost of owning a home relative to other consumer expenditures, the inflation measure as currently constituted has only limited value. 

The CPI's housing methodology ignores reality.  It disregards the values and decision making processes that influence consumer purchasing decisions.  While these ethereal, value-influencing preferences may not be easily quantified, and as such are ignored by “academic economists”, they exist and should be captured in calculating the real rate of the consumer price changes.


Follow-On Analysis of Historical Inflation/Deflation:  "The United States Continues to Experience Real Price Deflation"