If you haven’t read parts one and two of this series, you might want to go back and read those before you read part 3.
As we have discussed in the previous segments of this series, the CPI index is a measure of inflation. Now I will address how I think the way CPI is calculated contributed to our recent real estate boom and subsequent bust as well as our current recession.
In 1983 a major change was made to the way CPI was calculated involving homeownership. They switched from an asset approach to rental equivalence. Instead of using the price you paid for your home, they started using the amount of rent you give up by not renting your house. In other words, they began treating living in your own home as an opportunity cost.
During the recent real estate boom, house prices skyrocketed, as we all know. However, rents remained relatively stable. When credit was flowing, people didn’t want to rent; they wanted to buy. That kept rent prices stable. Because CPI is calculated based on rental equivalence, inflation was kept in check. The Fed was able to argue that inflation was tame, giving them license to cut interest rates and fuel the economy. We all know the end of the story, of course.
If actual house prices had been used instead of rental equivalence, the price increases in housing would have pushed the CPI index up. In other words, inflation would have been a higher number. I doubt interest rates would have been taken so low or kept there for so long if inflation had been higher. Higher interest rates would have meant higher interest rates and less available credit, and less credit would mean that the real estate boom would never have happened, at least not to the degree that it did. The boom would have been smaller, there would have been no bust, the economy would be more stable, and we surely wouldn’t be in a recession.
During the real estate boom, CPI told us that there was no inflation in housing even though we could see the prices going up. What is worse, housing is the largest single component of the CPI calculation! Rental equivalence is flawed. It understated inflation during the housing boom, and it needs to be corrected, lest the financial mess we are in today gets even worse. Home prices need to be put back into the CPI index right away.
by Wade Young
Wade, thanks for the education on the CPI. it does make a lot of since, was there ever a reason on whey they put the rent in place of home price? was it they jsut didnt want to face that infaltion was going to happen and so they were jsut padding the numbers by using rent? aither the damage is done and we need to not point fingers we jsut need to get it fixed. thanks for all the posts
VA loan–
I don’t think we will ever know their thinking. There is some good logic to rental equivalence, though, so it may or may not have been about keeping the CPI number low. For example, rental equivalence essentially represents the amount of your house that you are “consuming,” for lack of a better term. The rest is investment. I know that there were many reasons, including this one, that the switch was made. I think rental equivalence probably looked good on the drawing board but hasn’t worked out well in hindsight. Then again, it might have all been a ruse to keep the inflation number pretty. And maybe it was some of both.