IS THE CURRENT INFLATION INDEX ACCURATE?

IS THE CURRENT INFLATION INDEX ACCURATE?
By P. H. Lester, Sr.
December 11, 2007 (& updated January 4, 2007)

In the early 1980’s several changes were made in the Consumer Price Index (CPI).

Computed by the Department of Labor (Bureau of Labor and Statistics), the CPI is a bundle of goods that many of us – government, private sector and academicians rely upon. From time-to-time, DOL revises this bundle of goods to take into account changing consumer patterns and other factors.

One major change was the decision to remove house prices (single family homes) and replace them with equivalent rental rates. “Until the early 1980’s, the CPI used what is called the asset price method to measure the change in the costs of owner-occupied housing.”[1] One reason to make this modification was the fact that using the asset price method (the purchase price of an asset) lead to inappropriate results because it included assets purchased for investment purposes. Out of this dilemma, the “rental equivalent approach” was born.

While this may seem reasonable at first blush, in the years leading up to the sub-prime collapse in October of 2007, many markets experienced extraordinary increases in the cost of homes. While rental rates increased at a reasonable 3 – 4% per year, in many sub-markets across the country the cost of housing (owning a home) escalated at double digit rates.

If this variance was included in the CPI, the cost of inflation from 2000 - 2006 would easily be 6% and depending upon the area of the country you live in, it may well have been in excess of 8%.

Additionally, it leaves out an important segment of the market – home owners. In 2007, the census bureau reported that over 67.2% households were owner-occupied. The balance, roughly one-third, rent their homes. [2]

For years, we would gather at neighborhood parties and wonder, "who in the world can afford the houses that are going up down the street, or worse still, if my children want to live in this area, they will be working for years just to come up with a reasonable down-payment." In fact, many people we need to make our community viable (teachers, technicians, analysts, nurses, etc.) can no longer afford homes in our area. And, even if you could afford a home, your annual salary increases, which are often benchmarked against the CPI, are lagging behind the actual inflation rate when it is adjusted to include the cost of home ownership.

UPDATE (Jan. 3, 2007):

A study released today, and reported in the Wall Street Journal states that "US house prices would likely have to fall "15% over five years, assuming rents rose 4% a year." [3] The article went on to state that from 1960 - 1995, annual rents fluctuated at around 5% to 5.25% of home prices until 1995. However, starting in 1996, home prices out paced rents, when home prices began to out-pace rent increases. By 2006, the home prices had doubled while over that same period, rents had only increased 48%.

[1] Bureau of Labor Statistics, “Consumer Price Indexes for Rent and Rental Equivalence,” Rental Equivalence – Background; www.bls.gov/cpi/cpifact6.html .

[2] US Census Bureau, “Historical Housing Tables,” Homeownership, www.census.gov/hhes/www/housing/census/historic/owner.html .

[3] "Home Prices Must Fall Far To Be In Sync With Rents." Wall Street Journal, Greg Ip, January 3, 2004, page 3.

QUESTIONS for STUDENTS of ECONOMICS:

1. Do you believe the current way the CPI is calculated adequately reflects the percentage increase in the cost of living?
2. If you believed that inflation was running 3 – 4 % per year, but then found, when the increases in the cost of home onwership were factored in, that the actual inflation rate in your area was closer to 7 or 8%, how would that change some of your decisions?
3. It is easy to shoot holes in the work of others. If you think the current method is inadequate, how would you propose to more accurately compute the CPI in the future?
4. At what point would you consider selling a house and renting (it seems to be relatively cheap)?
5. If you are not a home-owner, but are renting, what does the rapid increase of the cost of homes since 1996 mean to you?
6. If you were a builder, would you be building today? And if so, what would you build: rental units or homes? Why?