Inflation May Be Understated Without Home Prices

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The big question these days is how hot will inflation get and will the higher prices really be temporary, as the Federal Reserve and many forecasters predict. 

But what about where we stand right now? Is the current data even accurate? Some economists say we may be underestimating pressures because inflation rates don’t properly capture the recent surge in home prices. They say the misleading data puts the Fed—which can control inflation with its benchmark interest rate but has so far chosen not to—behind the curve.

Key Takeaways

  • The Consumer Price Index doesn’t measure appreciation in home prices, which have been rising rapidly and are at an all-time high.
  • If housing prices were taken into account, core inflation would already be running at 6%, some economists say.
  • The Federal Reserve has said inflation, surging only temporarily, isn't a reason to shift away from its easy money stance, but some economists point to the housing market as a reason they should rethink things.

“Monetary policy that supports the extension of easy money when house prices are rising at record rates makes no sense,” said Joe Carson, former chief economist at the investment firm Alliance Bernstein. “It's one thing to misread the tea leaves of an asset bubble, but it's another thing to be the enabler.”

The year-over-year inflation rate in the Consumer Price Index jumped to 4.2% in April from 2.6% in March, and core inflation (excluding food and energy prices) accelerated to 3% from 1.6%. But Carson says both would be twice as high—so 6% for core inflation alone—if the actual surge in home prices over the past year were taken into account. House prices have soared as buyers seeking more space in the pandemic rushed to take advantage of low mortgage rates.

Target Rate of 2%

The Fed has been relatively unshakable in its assessment that keeping benchmark interest rates at virtually zero and maintaining its bond-buying program—what’s often referred to as its ‘easy money’ policy—is the right approach to healing the economy as it emerges from the COVID-19 pandemic.

The Federal Open Market Committee (FOMC), the policy-making arm of the Fed, targets an average core inflation rate of 2% over the long term, and has signaled it’s not going to raise rates for what it sees as “transitory” increases stemming from pandemic-era supply and demand issues. It expects inflation to rise above 2% this year, but then ease back toward its target rate when the economy comes back to equilibrium, meaning when supply and demand fall back into place.

The committee in April voted unanimously to keep policy unchanged, even though, as FOMC minutes released on Wednesday showed, some Fed officials have noticed “somewhat elevated” valuations in the housing market. The minutes also revealed that some FOMC participants thought “it might be appropriate at some point” to discuss “a plan for adjusting the pace of asset purchases.”

'Complete Baloney'

Here’s the concern about the apparent disconnect between inflation figures and housing prices. The Bureau of Labor Statistics (BLS) considers homes as investments, not a consumption or service item, so house appreciation isn’t accurately reflected in the Consumer Price Index (CPI). Housing does comprise about a third of the weight in the CPI, but it’s reflected as rent and owners’ equivalent rent (OER), which is what a homeowner would charge if renting out their home. 

In  April, OER, which makes up about 24% of the weight in the index, rose 2% year over year, and rent gained 1.8%, according to BLS.

Given that, by almost any measure, the housing market is on fire, the “house price inflation in CPI is of course, complete baloney,” Wolf Richter, founder and publisher of Wolf Street investment blog, wrote in March. Single-family homes sold for a record high median price of $334,500 in March—18.4% higher than the same period a year ago, according to the National Association of Realtors.

One problem is that the BLS measures the cost of rent every six months, which may not be enough to keep up with the fast-moving housing market. What may be worse is that OER is not a true market price, but rather an interpretation by the homeowner. BLS computes the OER by asking homeowners, “If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?” 

The upshot is that the boom in the housing market—one of the few bright spots in the pandemic economy—may be at least partially missing from the CPI calculation, a calculation that’s closely watched by Fed policymakers.

It should be noted that the Fed also looks at inflation as measured by the Personal Consumption Expenditures (PCE) Index from the Bureau of Economic Analysis, which historically runs cooler than the CPI. The PCE includes rent and OER components, but their relative weight is lower than in the CPI, which contributes to a cooler reading than CPI on inflation.

“I think it is a story that is not given the attention it perhaps deserves,” ING Chief International Economist James Knightley said in an email. The red-hot housing market “does risk leaving overall inflation higher for longer, which could necessitate earlier and more sustained policy tightening down the line than the Fed are currently acknowledging.”