The consumer price index (CPI) is set to be enhanced, with a new version published to include housing costs, it emerged this week. Although rent is already included in the CPI the costs of owning a home are not, despite it representing roughly 10 per cent of consumer spending. The Consumer Prices Advisory Committee (CPAC) which published the report (and is recommending the change to the UKSA) see this omission as the single biggest weakness of the CPI.
The CPAC got the ONS to do the (rough) maths on three new CPI measures which include housing costs defined in different ways. The three methods are called: net acquisitions (this treats housing as part consumable good and part asset), rental equivalence (which treats housing as a capital good which provides services) and narrow user cost (similar to rental equivalence but also includes the opportunity cost of having money tied up in a house). Detailed descriptions can be found at the end of the article.
Lets have a quick look at the new rates. Pre-recession, during the 1997 – 2008 period, the rental equivalence measure is the most closely linked of the three to the CPI. Both net acquisitions and narrow user costs sit above the base CPI rate with narrow user costs usually a tad higher of the two. This is because house prices were rising strongly in real, inflation-adjusted, terms. But the relationship was very different during the recession. To illustrate this I have prepared this graph that shows the annual change of GDP plotted against the difference between the annual change of the CPI and the CPIH (net acquisitions version).
Our created difference series turns negative in 2008 reflecting the fall of the CPIH annual rate below that of the aggregate CPI. House prices were falling sharply in the recession while the CPI kept rising, albeit at a low rate. In the wake of the recession, stable house prices have again closed the gap between the various CPI measures.
I think that the point to take home from this report is that the CPI will hopefully be becoming more relevant to people’s lives with the inclusion of house prices and costs. It will have a noticeable impact on the index but for those that want to do without, the CPI as we currently know it will still be around.
As always the data can be found here on Timetric.
The report can be found here.
As promised a more in depth description of the new indexes:
1. The net acquisitions approach treats a house as the purchase of a good which is part asset (the land) and part consumable (the house). Changes to the price of the house, plus changes in the costs associated with buying and maintaining a house (e.g. major repairs, transfer costs and dwellings insurance) would be included whereas changes in the price of land and related transactional costs would be excluded. This measure is set to become the method implemented in Eurostat’s Harmonised Index of Consumer Prices (HICP).
2. The rental equivalence approach treats a dwelling as a capital good that provides a flow of services that are consumed each period. Such services encompass shelter and security of tenure. The value of the flow of services that owner occupiers’ receive is assumed to be the same as the rent that the dwelling might attract in the tenanted market. Rental equivalence imputes owner occupiers’ housing costs from the rents paid for equivalent rented properties.
3. The narrow user cost approach treats a dwelling as a capital good that provides a flow of services that are consumed each period. Under this approach however, estimates are made for each of the individual elements of the costs of the services. These include an opportunity cost to the owner occupier of having money tied up in their dwelling rather than being available for some other purpose, plus depreciation and recurring costs such as maintenance.
The report concluded that the rental equivalence approach was too subjective and has recommended that it should be discontinued. The other two were approved for further development over the next two years by the ONS.
The conclusion of this article is in error in stating that the CPAC rejects the equivalent rent measure but retained the user cost and net acquisitions measure for calculation of pilot indexes. In fact, it was the user cost approach that, quite rightly, was dismissed as too subjective and only the net acquisitions approach and the equivalent rent approach will be retained for calculating pilot series.
The US housing bubble was caused partly because the US Federal Reserve Board used the personal expenditure price index ex food and energy as its inflation indicator, an indicator with an owner-occupied housing (OOH) component based on equivalent rents which was ludicrously insensitive to the big surge in US housing prices. This makes it extremely unlikely, in my view, that the ONS would opt for the equivalent rent approach to OOH in an expanded CPI, if that index were to be continued to be used as the Bank of England’s inflation target.