Owners’ Equivalent Rent
The BLS publication explains How the CPI measures price change of Owners’ equivalent rent of primary residence (OER) and Rent of primary residence (Rent)
Housing units are not in the CPI market basket. Like most other economic series, the CPI views housing units as capital (or investment) goods and not as consumption items. Spending to purchase and improve houses and other housing units is investment and not consumption. Shelter, the service the housing units provide, is the relevant consumption item for the CPI. The cost of shelter for renter occupied housing is rent. For an owner-occupied unit, the cost of shelter is the implicit rent that owner occupants would have to pay if they were renting their homes.
The expenditure weight in the CPI market basket for Owners’ equivalent rent of primary residence (OER) is based on the following question that the Consumer Expenditure Survey asks of consumers who own their primary residence: “If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?”
A reader pointed out the BLS uses that question to determine the weight not the percentage, of OER in the CPI, something I had missed.
Nonetheless the question is absurd. Let’s continue.
Price Change for OER and for Rent Using the sample of rental units, the CPI calculates a measure of price change for each CPI index area for the Rent index and for the OER index. The first step is standardizing the collected (market) rents, putting them on a monthly basis, and adjusting them for a number of circumstances that should not affect the CPI. These include adjusting for any changes to the structure, such as changes in the number of rooms or bathrooms or in the type of heating and cooling equipment, or changes in the number of pets. These standardized rents are called normalized rents.
In addition the CPI adjusts the rent for the effect of aging of the rental units over time. The Housing sample collects the rents from the same housing units every six months. Consequently, each time the CPI observes the rent of a sample unit it is six months older. To account for this aging, an age-bias factor is applied to the current rent; this raises the rent slightly because the older unit is slightly less desirable. For example, a unit with a rent of $900 might have the rent adjusted to $901.
The CPI assumes that sample units reported to be vacant are transitioning to new tenants. Experience with rent data has shown that units tend to experience rent change when the tenant changes. To avoid missing this rent change for vacant units, the CPI performs a class-mean imputation to estimate their rents.
The estimated current rent of a vacant unit is its previous rent times the average rent change of newly-occupied units. For example, if the average rent increase for new tenants in an area was 5 percent, a currently-vacant unit that rented six months earlier for $1000 would have a current estimated rent of $1050.
To calculate the relatives of change for the Owners’ equivalent rent index, the CPI calculates what it calls the pure rent from the normalized rent, removing the value of any utilities included in the rent. Owner-occupants pay for their own utilities and the CPI accounts for them outside of Shelter.
Thus, OER prices may be in the ballpark if you believe the above procedure is accurate, but the weight is determined by a ridiculous process.
Regardless, home prices are not in the CPI and they used to be. The BLS explains homes are a capital investment. OK fine.
Anyone with kids in college has their own set of problems.
What about medical expenses? A large percentage of people are sheltered from huge medical increases because their company picks up the tab. Those on Medicare or Medicaid see low increases.
But what is the true cost of medical service?
Anyone who buys their own insurance understands the cost has risen dramatically.
The BLS averages this all together and comes up with a ridiculously low number that anyone who buys their own insurance would laugh at.
Inflation vs CPI
Is it only inflation if the consumer pays for it?
The CPI purportedly measures consumer inflation. The problem is “consumer inflation” is a very poor measure of actual “price inflation”.
It’s inflation that matters, not alleged consumer inflation.
But the Fed, economists, and mainstream media all have their eyes on the CPI.
Mish
Get rid of hedonic adjustments which reduces costs further by saying the product you are buying are better quality or offers more features therefore prices are reduced even further. Typically you do not have a choice in these products you buy.
My preferred measure of inflation is the GDP deflator. Per Investopedia “The GDP price deflator is a more comprehensive inflation measure than the CPI index because it isn’t based on a fixed basket of goods.”
Reifying “inflation” into one thing is probably more confusing than clarifying. Prices vary across so many axes, how could condensing all of those data points down to one statistic give us any real understanding.
You’re not understanding my comments, which I’m used to. I’ll clarify here for anyone else who cares (probably no one, but anyway…).
Regarding ocean temps I was discussing accuracy, not the integrity of conceptualizing oceanic heat distribution. There are only a few thousand buoys taking temps below the surface of the oceans, but we expect enough accuracy to plug into computer programs that will tell us how much heat will be on the planet decades from now?! This is one of many follies of climate models. GIGO.
My point about reification of CPI is clear. “Inflation” is not one thing, but it is easy to forget that when using a statistic, because a single number feels like a measurement of a thing, like the weight of a person. In reality prices go up and down differently for different products and services, in different locales, in different market segments, etc. The danger of relying on such a statistic for decision making is that it will necessarily skew across all of these categories according to the mathematical method used. Housing and equity prices being under-represented (and that people argue about this), as is Mish’s point, is a case in point. But even if we could come up with a better statistic that jams in housing and equity price data and makes everybody happy, there’d still be some skewing of meaning within the statistic that may lead to bad decision making.
I’m not saying don’t use statistics (or measurements with fat error bars), I’m saying one has to remember what these numbers actually are, and resist treating them like a form of knowledge that they aren’t. There is always a powerful temptation to imbue undeserved meaning onto crunched numbers.
This touches on that: link to technologyreview.com
All manipulated to keep social security payments from rising as more people flood into receiving it rather than paying it. The Ponzi scheme is getting squeezed more quickly now so expect more crazy ways to curb the effect in the future.
Little guy takes on Wall Street. https://www.youtube.com/watch?v=J9-SXcPGdkg&feature=youtu.be&ab_channel=PePPeMusic
I think it is a mistake to lump all inflation measures into one percentage. It would be much more useful to split it into several different figures depending on level of income, essentially divide it by class. Lower classes have a different inflation rate from the middle or upper classes because they consume differently for example. Putting it all together in one percentage makes as much sense as using GDP to measure the wealth of a country’s citizens. It gives a false picture and consequently leads to faulty policy. One size does not fit all.
Economists in general over-simplify this way, they want to promote two dimensional solutions for a three dimensional world.
I don’t like the idea of three separate economic schools, each acts as though the others have absolutely no merit, yet all three have valid components that are effective under different conditions.
I completely agree with the premise, inflation metrics should be based on cost of living, all of it.
The assertion that home price should be excluded because it’s an investment is a crock, home price directly affects mortgage/rent, the single biggest monthly cost to most Americans….it directly affects disposable income.
The Fed and most regulatory conglomerates have gradually evolved to focus on C-suite or Wall street’s perspective….they’re completely insulated from the reality of Joe middle class.
Or, perhaps the Fed prefers to pretend there’s no inflation or problem with relative wages, thus assuring the continuation of household debt and resulting revenues to the banks that comprise the Fed.
I’m not of the “abolish the Fed” school, but the Fed really needs a shake-up, a change in leadership that represents ALL of America, not just bankers.
If “the Fed really needs a shake-up, a change in leadership that represents ALL of America, not just bankers”, the only way it can happen, I believe, is to abolish the Fed and create a new smaller and enlightened entity.
To “abolish” the Fed, even for a brief period, would be economic insanity.
It’s like noting certain cops have been taking kickbacks from local gangs, we can’t just eliminate the police, so we put checks and balances.
Simply add to the existing Fed membership, mandate more equal representation for all sectors/industries…perhaps even consumer/labor representation, provided they have prerequisite acumen for the position, to assure their bias isn’t so lopsided toward commercial & investment bank interests.
Whether the Fed has intentionally pressed the economy for decades to be so loan dependant, or they’ve just been a backstop for politicians to avoid hard decisions that hurt their campaign donors, it’s completely obvious the Fed has a lopsided representational cross section of the true economy.
Silly to aggregate home and other asset prices into a combined measure of inflation. They are two different issues.
Using monetary policy to address #1 (unemployment) is the wrong tool since it also results in more money sloshing around and higher asset prices. What is needed is effective fiscal policy aimed at reducing income and wealth inequality.
True inflation is impossible to measure because of derivatives on commodities which drive up the price of everything. When you can speculate in commodities without having to take delivery of end product then this makes measuring true demand and supply of that commodity a near impossibility.
The most important aspect of understanding this whole charade is that it should influence your decisions around money.
If you think there is no strong trend toward rising housing costs, well, then, you might as well rent and avoid the headaches of home ownership.
If you think real cost inflation is much higher than that reported in the CPI, then you might look at housing not JUST as a capital investment, but as a preferred investment.
To that, add the Fed gift to long term borrowers that would let current buyers lock in mortgage money at rates that are far below the historic averages for 30 years….which sets up a second additional potential arbitrage against inflation.
To that add the government gift of tax reduction and tax deferment on real estate investments….and you have a strong argument for owning some RE. jmho.