The United States Continues to Experience Real Price Deflation
The methodology underlying the Consumer Price Index (CPI), the Government’s measure of inflation, was altered in 1983 to exclude housing prices. As illustrated in "The CPI Inflation Methodology is Deeply Flawed and Defies Housing Reality", the rationale for the adjustment was intellectually dishonest.
The Government modified the methodology as a matter of convenience to report less volatile and milder price changes. A concept dubbed Rental Equivalence replaced Housing Prices. As is graphically illustrated below, this substitution was absurd. The Government might as well have replaced housing prices with a straight line reflecting 2.9% annual inflation. I note that Rental Equivalence was completely unaffected by the rapid rise and fall of home prices during the Housing Bubble.
Even if the 1983 methodology change was not implemented with intent, the decision had the functional effect of ignoring a large and meaningful source of inflation during the Housing Bubble and is presently under-reporting deflation.
Estimating Real Historical Inflation and Deflation by Adjusting the CPI
In an effort to demonstrate the dramatic impact of the CPI’s indefensible exclusion, I have adjusted the metric to include the cost of housing. In doing so, I am using the pre-1983 methodology and producing a measure of “Real Inflation”.
There are Limits to Accurately Recasting the CPI Data
Without access to specific CPI data, I am forced to use a proxy for the nation’s housing price performance. I relied upon the Case-Shiller 20-City Price Index because it utilizes the best methodology available to capture real price changes.
Given the relatively small sample size of Case-Shiller (20 Cities), the price change of the nation’s housing as a whole is likely to be different. Furthermore, the index consists of several cities disproportionately affected by the Housing Bubble and, as such, likely overstates national price movements. At minimum, my adjusted inflation measure is an excellent estimate within these 20 cities.
The other challenge is that the relative component size of items included in the CPI changes over time. For instance, Rental Equivalence increased from 21.06% of the CPI in 1995 to a 24.43% weighting in 2008. I am unable to estimate how the relative component weighting would have evolved were Housing Prices used instead of Rental Equivalence. As such, I have maintained the historical component weighting but substituted the Case-Shiller Index. Given the dramatic increase in Housing Prices relative to Rental Equivalence in recent years, this methodology understates the weighting of housing and, as such, under reports inflation and deflation.
As a whole, the adjusted CPI figures are not precise but serve as an excellent proxy for demonstrating the inadequacy of the current Rental Equivalence methodology.
The Formula Used to Recast the CPI Index is as Follows:
“Adjusted CPI Index” = “CPI Index” + (“Rental Equivalence Component Weighting” * (“Case-Shiller 20-City Price Index” – “Owner’s Rental Equivalence Index”))
(all index values were set to 100 for January 2000)
Welcome to Reality
The Government has been understating rapid, historical inflation and the existence of current, ongoing deflation. During the mania portion of the Housing Bubble, with the exception of 2001 (September 11th), inflation ranged from 4.7% to 8.0% annually. In 2008, overall price deflation was 6.5% and continues through today.
The Government modified the methodology as a matter of convenience to report less volatile and milder price changes. A concept dubbed Rental Equivalence replaced Housing Prices. As is graphically illustrated below, this substitution was absurd. The Government might as well have replaced housing prices with a straight line reflecting 2.9% annual inflation. I note that Rental Equivalence was completely unaffected by the rapid rise and fall of home prices during the Housing Bubble.
Even if the 1983 methodology change was not implemented with intent, the decision had the functional effect of ignoring a large and meaningful source of inflation during the Housing Bubble and is presently under-reporting deflation.
Estimating Real Historical Inflation and Deflation by Adjusting the CPI
In an effort to demonstrate the dramatic impact of the CPI’s indefensible exclusion, I have adjusted the metric to include the cost of housing. In doing so, I am using the pre-1983 methodology and producing a measure of “Real Inflation”.
There are Limits to Accurately Recasting the CPI Data
Without access to specific CPI data, I am forced to use a proxy for the nation’s housing price performance. I relied upon the Case-Shiller 20-City Price Index because it utilizes the best methodology available to capture real price changes.
Given the relatively small sample size of Case-Shiller (20 Cities), the price change of the nation’s housing as a whole is likely to be different. Furthermore, the index consists of several cities disproportionately affected by the Housing Bubble and, as such, likely overstates national price movements. At minimum, my adjusted inflation measure is an excellent estimate within these 20 cities.
The other challenge is that the relative component size of items included in the CPI changes over time. For instance, Rental Equivalence increased from 21.06% of the CPI in 1995 to a 24.43% weighting in 2008. I am unable to estimate how the relative component weighting would have evolved were Housing Prices used instead of Rental Equivalence. As such, I have maintained the historical component weighting but substituted the Case-Shiller Index. Given the dramatic increase in Housing Prices relative to Rental Equivalence in recent years, this methodology understates the weighting of housing and, as such, under reports inflation and deflation.
As a whole, the adjusted CPI figures are not precise but serve as an excellent proxy for demonstrating the inadequacy of the current Rental Equivalence methodology.
The Formula Used to Recast the CPI Index is as Follows:
“Adjusted CPI Index” = “CPI Index” + (“Rental Equivalence Component Weighting” * (“Case-Shiller 20-City Price Index” – “Owner’s Rental Equivalence Index”))
(all index values were set to 100 for January 2000)
Welcome to Reality
The Government has been understating rapid, historical inflation and the existence of current, ongoing deflation. During the mania portion of the Housing Bubble, with the exception of 2001 (September 11th), inflation ranged from 4.7% to 8.0% annually. In 2008, overall price deflation was 6.5% and continues through today.
Posted by Whitney Ross at 7/8/2009 10:02 AM 
Categories: Dismal Reality, Economic Analysis, The Government is Lying, The CPI Fraud
Categories: Dismal Reality, Economic Analysis, The Government is Lying, The CPI Fraud
It is very difficult to use house prices in any inflation measures. Notional home values go up and down and they can be measured or estimated. But the effect of these value excursions on inflation depends a heck of a lot on what fraction of households are actually experiencing true changes in housing costs.
My house of 2001 I guess notionally cost more and more right through summer of 2006, but my monthly cost of housing - the size of the check that I wrote every month - never changed. According to this article my house was contributing to a component of unmeasured inflation. But the only person paying for the house - me - never paid a penny more for it all that time, so it did not contribute to inflation during that period. Likewise the house that my wife and I bought last summer probably has slumped in value since then, notionally contributing to deflation. But my wife and I still pay the same amount that we paid last summer, so this house is not really contributing to deflation.
If the housing component of inflation is supposed to represent what people are really paying for shelter, then neither rental parity or a Case-Shiller type metric are proper alone. It would more likely be some blending of the two concepts with adjustments for the stock of housing that is fully paid for by the occupants.
Reply to this
You raise some interesting issues. But I believe you are confusing personal expenditure and financing decisions with the concept of consumer price inflation.
There is no doubt that your “personal cost-of-living changes” are different from that of other people and the nation in total. No one buys each item in the CPI Index in the relative component weighting used to estimate the nation’s consumer inflation.
Opportunity Cost and Cumulative Consumer Price Changes
The CPI is not a measure of your individual expense decisions. Calculated inflation is a measure of the cumulative consumer cost changes for the country as a whole.
Prices change regardless of whether you individually choose to purchase the items experiencing those fluctuations. It is the opportunity costs of all the items available to you for purchase that are changing. You are not immune to price inflation because you decide not to buy a house, boat, car, TV, Computer or bicycle.
Ownership Does Not Allow You to Ignore Inflation
Owning an asset does not exclude its inclusion in the measure of price inflation. The value of your house is volatile whether it affects your monthly expenses or not. Were anyone else in America to buy your house they would certainly pay the inflation-adjusted value. It is the price change relative to potential consumers that matters.
Financing Decisions are Irrelevant to Inflation
“The size of the check” you write each month to own a home is irrelevant to inflation. Monthly expenses are determined by financing decisions not by prices. Inflation isn’t influenced by whether a buyer chooses to put 80% down to buy a home or 20%. A person who takes out a fixed mortgage is not immune to housing related inflation for the next three decades.
You could have a 15-year mortgage on a house and pay a fixed monthly payment. If you bought a functionally identical house next door for a higher, inflation-adjusted price, but used a 30-year mortgage your monthly expenses might be lower but the price you paid for the asset would be higher. Using your logic this is cost deflation when in actuality prices have increased.
Financing decisions attached to a non-current purchases are irrelevant to the rate of inflation. If you bought another house, car, boat, TV, computer or bicycle today you would still have to pay the prevailing market price regardless how you financed the purchase.
Your Specific Example
You presently own two homes. That does not mean that the price of your potential third house is not changing regardless of whether you choose to buy it. Also, your two current houses represent potential purchases for me and other Americans, and from that perspective must be captured by inflation.
Reply to this
I think the nation's housing market is facing new downward pressure as holders of subprime-mortgage bonds inundate the market with foreclosed homes at prices that are much lower than where many banks are willing to sell.
"Experts say this is a bad omen for residential real-estate prices and homeowners trying to sell or refinance, because the fire sales, many to cover soured subprime loans, put downward pressure on the value of nearby homes. All of this undermines federal efforts to stabilize the housing market and revive the broader economy.
"While the banks are trying frantically to get loans off their books, they face the problem of large shadow inventories of housing being dumped on the market, which would depress prices further," said Anthony Sanders, real-estate finance professor at George Mason University in Fairfax, Va."
With high joblessness, it is only normal that subprime-mortgage holder would like to sell their properties since they are not sure of the employment status in the coming months.
Read more http://www.housingnewslive.com/is-the-housing-market-recovering.php
check out http://www.housingnewslive.com/blog.php
Reply to this