Deflation and Housing Costs

Today’s CPI release shows an eye-popping 4.7% year-over-year decline in the headline price index.  Most of the decline is due to a 42% year-over-year decline in mortgage interest (which has a weight of 6.7% in the index.)  Excluding mortgage interest, the rate of deflation is 1.2 percent. 

This brings up an issue which has been an old chestnut among economists of a certain disposition, namely the appropriate treatment of housing costs in a cost-of-living index. My opinion on this (drummed into me years ago while a junior lackey at the Fed) is that mortgage interest rates should not be used to measure the cost of housing and that housing costs are best proxied by matching housing units with equivalent rental properties.  This owners-equivalent rent is a major element of the US CPI.

The idea here is that the cost of living index should not depend on the particular financing method that people use to buy homes. If, for instance, we all inherited a large lump sum tomorrow and paid off our mortgages, then the mortgage interest element of the CPI would disappear (once re-based).  However, this would not mean that housing had no cost—the decision to pay off the mortgage is a financial one and the money could have been invested in other financial instruments.  (For similar reasons, I have also never agreed with people who argue that house prices should be included in cost of living indexes.)

In any case, it’s interesting to note that rents are also well down over the past year, declining 16.4% over the past year (see page 4 of this release).  So using this figure in place of the mortgage interest cost would still imply deflation of 2.2%.  (Of course, this is a crude calculation since the rental sample is different from the sample of owner-occupied homes and if you were doing all this correctly, you’d probably have different weights.)

One reason this issue matters is in relation to welfare benefits.  Those on welfare who don’t own their own home have not experienced a 4.7% decline in their cost of living and this is one reason to be careful in arguing, as many have, that the falling CPI has implied real benefit increases of whatever percent for recipients.

9 replies on “Deflation and Housing Costs”

I mentioned differential impact of inflation once before. As David Madden pointed out not such a big deal overall. But Karl’s point in last para is important. A similar point relates to fixed mortgage holders (anecdotally a lot of the last lot into the housing market, younger, riskier jobs so perhaps now jobless) – the falling interest rates and deflation lie behind a lot of the justification for budget policy (offsetting taxes) but fixed mortgage folks neither get neither compensatory effects.

I’d tend to think that ‘equivalent rental comparison’ actually disguises inflation! it is that practice which meant that while house prices spiralled out of control in the US that there was never inflation (due to rising housing costs) reflecting the effects of that. Equally using mortgage interest in a low rate environment does the same if you base it from that.

CPI – needs to reflect actual costs, opting for equivalents is equally distortive. if rents are down 40% due to massive rental property over supply does that mean that people who bought two years ago benefit? Does it more accurately tell us about the economic environment we live in?

Really what this tells me is that we don’t actually understand our own property market, if the land registry can record mortgages on properties and the like then we could (if the information was used) have an actual idea of the true picture. the real missing link is the actual selling prices which are impossible to find out due to the ‘private treaty’ practice, but if revenue were to ensure the folks in dublin castle reported them – because solicitors have to report them in one form or another for stamp duty purposes – we could get them. cross this with the more available rental market interpretation and you might get a better picture.

the real trick is to get several agencies in Ireland working together, and frankly, that’s the real stumbling block.

One interesting thing about the CSO inflation numbers — outside of energy and housing, which is admittedly a big chunk of the picture, there are important sectors of the economy where prices are still increasing quite a bit. Education (+3.5), health (+4.5), and a load of “miscellaneous” services (+8.6). It may be deflation, but it’s not balanced deflation.

“Those . . who don’t own their own home have not experienced a 4.7% decline in their cost of living” – but neither did they experience such high inflation when interest rates were rising. In the long run [when we are all dead] there is little divergence between inflation measured including and excluding house-financing costs.

[…] Originally Posted by kerrynorth They do. Its called the HICP. Its a European harmonised index of consumer price inflation. It was -1.7% for the 12 moths to April. karl Whelan has a post on how best to handle mortgages in the CPI The Irish Economy Blog Archive Deflation and Housing Costs […]

[…] Sometimes, it’s easy to forget – when you see interest rates of just 2% or so on your savings that the real return on savings can be quite high. Even with zero interest rates – as people often have in their current accounts, it may actually be the case that there’s “never been a better time to save”! Earlier this week the latest CPI figures were released, showing an annual fall in prices of almost 5%, as discussed by Karl Whelan on the Irish Economy blog. […]

Rents in Dublin are falling faster than elsewhere, so Karl’s point on correcting the weights across rental and general samples is a good one – the overall effect, though, would not be that large, and might only knock a couple of points of the 16% fall.

On a self-interested side-note, interesting to see the CSO’s rental index come more and more into line with the rental index! (Last year, it had lagged by up to three months.)

Who audits these statistics?

Given their use for pay, pensions and the large role of the government in the economy, the conflict of interest is notable but never stressed!

This was one reason the civil service was offered benchmarking: they were walking off to better paid jobs in the private sector.

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