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.