Tuesday, July 19, 2005

CPI and Housing

The CPI, which measures inflation, looks at housing rental prices but not purchase prices. Since rental prices have remained flat to declining, but purchase prices have risen, you could argue that the CPI may be understating true inflation.

Macroblog (another Chicago GSBer) says that the CPI does not understate true inflation because
The CPI weighs housing on the basis of what the average person spends on housing (implicitly via opportunity cost) and not what a new, first-time homeowner spends. Again, if you are already a homeowner (without appealing to opportunity costs), you have NO cost-of-living rise as home prices rise. You bought your home before prices went up. (And remember, you have to be a first-time buyer, or the rising gains from selling your old home will largely offset the rising costs of the new one.)

Now, I don't know exactly what the proportion of the housing market these people represent, but I would bet they are quite small. So, by the approach implied by the blog, one would weigh the CPI housing MUCH smaller than the 23 percent of the basket it currently commands. In fact, I wouldn't be surprised if the downward revision to the CPI from the reduction in the component's weight had a much larger impact than the upward revision to the CPI from plugging in actual new home costs.
And besides, cost-of-living is a real cost and inflation is monetary (and therefore nominal) so CPI is not a great way to track it. This whole post is very good, and I recommend reading it through.

I would also add that there are two aspects to home ownership, consumption and investment. Consumption is the implicit rent, and investment is the expected appreciation on the underlying asset. A Consumer Price Index should absolutely look at the consumption portion and ignore the investment portion -- after all, was there general monetary inflation (ie. increase in nominal cash values) in the late 90s when the internet boom happened? If anything, the flow of money into stocks helped keep consumption costs down by offering consumers big discounts on anything that could be ordered online.

Similarly, just because housing prices have increased does not mean cost of living has increased, simply because rents (which is true consumption) have stayed flat. There is a housing bubble on, in that future price appreciation will almost certainly fall below current expectations, but this is not the same as saying there is inflation.

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