What Happens if Inflation Is Overstated?

The NYT’s Floyd Norris jumps the gun on CPI and Owner’s Equivalent Rent this morning:

Norris_oer_1"Since 1983, the government has measured the price of homes not by looking at house prices but by computing what it calls "owner’s imputed rent." That is the rental value of the house you own. It accounts for nearly a quarter of the entire Consumer Price Index.

When the change was made, the government provided statistics indicating that previous inflation rates would not have been very different under the new method, and that remained true until 1996.

Since then the home price index maintained by the Office of Federal Housing Enterprise Oversight has doubled, while the imputed rent figure has risen by less than a third.

Had the government computed the Consumer Price Index using actual home prices since 1996, I estimate that it would have risen by an average of 4.1 percent a year, as opposed to the 2.5 percent reported. The core rate — inflation excluding food and energy costs — would be 4.2 percent, not 2.2 percent.

Perhaps the Federal Reserve was too hesitant to raise rates, and thus allowed speculative bubbles to form, because it was seeing inflation through rose-tinted glasses.

But now the problem could be the opposite. If the housing boom is ending, rental costs may start to catch up with house prices. The reported inflation rate would be higher than the real rate, at least to people who say the best way to measure home prices is by measuring home prices."  (emphasis added)

Here’s the problem with this approach: After years of CPI definitively understating Inflation, we are now at a junction where its a slim possibility that — off in the future — when CPI may (repeat MAY) possibly overstate inflation. 

For that to happen, rents would have to tick up significantly. With OER about a third of the core CPI, medium size increases in rent beyond the historic trend would have an impact on BLS reported inflation data. 

Think about this for a moment: In order for that to happen, we would needs a fairly hefty shift in demand for rental properties nationwide – beyond the available supply. We have yet to see any evidence of this shift; Given the massive buildup in inventory recently, there is still much more than enough supply to meet demand.

Indeed, considering all the spec properties built/bought — think of the gazillion new condos in Florida, the surge in Las Vegas, Arizona, San Diego — lots of rookie Real Estate speculators may soon find themselves as unwilling landlords. This will especially be true for those who are unable to sell their properties beause they cannot sell for less than their (interest only) mortgages. If they cannot absorb the big hit, their only option is RENT IT.   

To summarize:

1) Inflation has been significantly understated by the BLS for the past 10 years due to OER;

2) With the Real Estate boom cooling, the possibility exists for an upswing in rentals sometime in the future;

3) If that occurs in significant enough numbers, that might in the future, overstate inflation;

4) However, before that happens, all the excess inventory built recently would need to be absorbed into the Real Estate market.

5) All this presumes the economy doesn’t slow all that much if at all;

Coming Soon: New Rental Property Supply:


Source: Northern Trust, New Home Inventory 1965-2005



Don’t look for OER to overstate inflation anytime soon . . .


UPDATE JUNE 10, 2006 6:27am

The WSJ reports "It’s no longer a renter’s market" as rental prices rise 3%:

"For years, rents have been flat or falling in cities nationwide — a result of the booming home-sales market, which transformed scores of renters into owners. But as the housing market cools, rentals are once again in demand, liberating landlords in many markets to raise rents at the fastest pace in years. They’re also cutting back on the goodies that previously helped lure tenants, such as a free month’s rent or a free DVD player.

While renters have had an easy ride for years, the current bout of rent increases could prove to be a jolt for many Americans, from seniors looking to downsize to recent grads looking for their own place. Average effective rents — or what tenants pay after taking concessions into account — are expected to rise 3% this year, according to Reis Inc., a real-estate research firm. Rents began picking up last year after several years of softness. As recently as 2002, rents fell 1%."


What Happens if Inflation Is Overstated?
NYT, June 9, 2006

Rising Rents Jolt Tenants
Cooling Housing Market Adds To Demand in Many Cities;
WSJ June 10, 2006; Page B1

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  1. spencer commented on Jun 9

    It is time for a correction and rents and home prices to converge. It could happen several ways, including flat rents and falling prices. But however it happens rents will be stronger then prices and cause the CPI to be stronger then if it were using actual prices rather then rents. It is already a significant reason the core CPI is accelerating this year.

  2. Cliff commented on Jun 9

    I’m so glad you posted this.

    I’ve been looking for a rental in Chicago and prices don’t seem to have increased. They are significantly below the price of a condo and renting seems to be a good bargain.

    However, I recently read an article stating the population of Chicago has declined and most of the condo’s have been bought by speculators and are unoccupied. I think that means that rents are not likely to increase anytime in the near future.

    There is definetly a glut of supply in the rental market.

  3. S commented on Jun 9

    Anybody know the REAL reason why the BLS doesn’t proportionally weight changes in house prices and rent based upon the actual mix in the communities surveyed to calculate the housing compononent of the CPI? It would seem to be the more intellectually honest approach.

  4. fred hooper commented on Jun 9

    S, the reason might be that COLA’s and SSI increases were historically pegged to the CPI. Changing the formula reduced the inflationary pressure on wage increases and retirement payments.

  5. Jonathan commented on Jun 9

    The cost of housing also needs to take into consideration the cost of financing and taxes. The equilibrium value of housing rise when interest rates fall and visa versa (duh…). Saying that housing is more expensive now vs. 10 years ago if incomplete if you don’t include the fact that interest rates (defined as the 10 year note) are 28% lower (6/6/96 vs 6/2/06). The change from 7% to 5% (again using the 10 yr note as a proxy) means that a 21% price increase was needed just to “break even”. That gets us from an index of 375 (in 1996) to 453 (vs a current level of about 550). The change in the tax law allowing couples to exempt up to $500k of gains ($250k for singles) from taxes might account for the rest. Could the real price of housing, when looked at that way, actually not have gone up at all?

    And rents are going up. At least where I live (in NYC). Natural housing buyers are postponing and renting, pushing rental rates up. As a landlord, I see this first hand. And it makes sense. Yes, those spec houses could become rental properties and those people will lose money (either as a landlord or a failed speculator) after costs. This is part of the natural price setting mechanism and not some apocalyptic doom.

  6. RW commented on Jun 9

    Brad Delong beats up on Norris for his comments WRT CPI calculation and housing (http://tinyurl.com/j9fqp) but I confess I find the explanation somewhat counterintuitive. Then again, I’m not an economist.

  7. Gary commented on Jun 9

    Kudlow and Company on primetime! Yahoo! I’m getting the popcorn ready. Seriously.

    Go Barry.

  8. trader75 commented on Jun 9

    Where I live rents are goin’ down, down, down… housing rents that is.

    Housing rents have been sky high here for the duration of the boom, as so many people have been using ‘creative financing’ to buy at any price, reducing the number of available rentals on the market.

    Now all the investors–in some shiny new neighborhoods every third house is an investment property–are starting to get worried. They are transitioning from making sure they get the rent they “deserve” on their button cute 3 bedroom to wondering how much longer they can make the monthly mortgage nut without a tenant. I am guessing housing rents will be a solid 20-25% lower across the board 12 months from now.

    That’s for desirable housing in a hot area though, where lots of naive investors piled in at the top… cheap apartments I have no idea. I could see rents on those creeping up as a glut of middle class folks find themselves in serious penny-pinching mode. But even still, a rise in low-end rents probably won’t offset the drop in higher-end here.

  9. royce commented on Jun 9

    Seems like the key would be to compare rents with the cost of homeownership per month (interest payment+taxes+maintenance). How fast have those payments gone up over the past three years?

  10. C commented on Jun 9

    “This is part of the natural price setting mechanism and not some apocalyptic doom. ”

    Ah, thank you for that!

    You make some very convincing points. The NY rental market may not represent the national average, though. My guess would be that with the oversupply of rentals and increasing demand will keep rental prices contained. This might even translate into a lower core CPI.

    Another factor I see is the tight labor market–low unemployment, low new jobless claims. (I don’t believe a very significant percentage of jobs are tied to the housing boom.) This should put upward pressure on wages, which will enable consumers to maintain their lifestyles.

    A period of moderately slower economic growth is healthy. It is still growth.

  11. Coitdeck commented on Jun 9

    I don’t see rents going much higher. When there is a divergance between what it costs to own vs. rent, costs to buy come down or costs to rent go up. First, we are in an overpriced market so buying costs are likely to come down, and second, people start paying more rent because they have to compete for available housing while wages go up and the economy is booming. That’s not what is happening.

  12. R. Masand commented on Jun 9

    I agree. Rents will not go up. But that will not prevent shills, such as Kudlow, from taking even the slightest uptick in OER to scream CPI distortion and use it to demand lower rates. The same people who never accepted the understatemt of inflation during the buying binge.

    And then there’s the administration subtle, but relentless, bias to understate inflation using hedonics and other such convenient sleights. So in no way is anything going to be allowed to overstate inflation. Sleep well.

  13. Alan Greenspend commented on Jun 9

    “My guess would be that with the oversupply of rentals and increasing demand will keep rental prices contained.”

    Nope, I think we’re on the peak of the downward slope of a very steep bell curve.

    Having been in NYC during several boom busts, especially the 80’s, I see no difference in this cycle, except in intensity. I was a landlord until last year when we cashed out and are now renting. Sold to a flipper, it’s still on the market.

    Our landlord has our brownstone on the market for a couple of million, we’re renting it for just a few thousand. Do the math.

    There is an astounding glut of new condo’s being built all over the city. NYC rents will be decreasing a little slower than the purchase price at first, and then accelarate.

  14. jm commented on Jun 9

    A problem will be that the same lack of common sense that led the speculators to buy unsaleable homes will also prevent them from being desirable landlords. Because my house requires major repair work, I’ve been thinking of renting while it’s being done, but I really don’t want to rent from someone who is on the road to bankruptcy and foreclosure. And after the homes are foreclosed and in the hands of the banks? I’ve never heard of banks renting foreclosed real estate — but will they drop the prices low enough to sell? Or will the homes sit empty? And will subdivisions half empty and half rented be good places to live???

  15. Groove commented on Jun 9

    Where I live, even though our house has appreciated substantially (30-40%) in 12 years, the payments for someone buying today would be only slightly more than what we originally established. This indicates to me that there has actually been disinflation in housing in my area because payments on the same house have not kept up with overall inflation. The difference is interest rates – nobody pays cash for a house.

  16. wcw commented on Jun 9

    Jeepers, that’s not true here.

    Let me go run the OFHEO index through the ten-year or a mortgage index if I can find one. I bet dollars to donuts you don’t see disinflation.

  17. toddZ commented on Jun 9

    I don’t buy this at all. Since home prices are up, rent prices will go up?

    1) increased home buying brings people AWAY from rental properties
    2) increased supply of rental properties with lower or stagnant demand = lower prices over time.

  18. trader75 commented on Jun 9

    Groove, where do you live? The rust belt? 30-40% over 12 years is around 3% a year. That’s not substantial by any stretch. You’re probably neck and neck with inflation and ownership costs.

  19. Barry Ritholtz commented on Jun 9


    Rents were suppressed by the rush to buy — that begat tons of new building and supply — the Real Estate market is cooling, with lots of excess supply around — and that should put a damper on rental prices

  20. Groove commented on Jun 9

    I calculated an exact number for appreciation (assuming I could sell it for what I think it’s worth) for my house, which is typical for my area – 44% in 12 years, or 3% per year. Payments on an equivalent 30 year loan, I estimate, are virtually flat, when they should have increased by some 40% to keep up with inflation. Median housing prices have skyrocketed more than 40% here, but that’s because people build ever-bigger houses, and that is *not* inflation.

  21. Groove commented on Jun 9


    Colorado, in a nice, but non-resort area. Not Denver, but equivalent to it.

  22. David commented on Jun 9

    Nice post and interesting comments throughout. I always thought it was odd that “we” could have it both ways: a bull market in housing prices ending in a soft landing and begeting a bull market in the cost of renting.

    Here in Seattle I’ve seen a number of homes that have had their “For Sale” signs changed to “For Rent.”

  23. Mark commented on Jun 9

    Does the primetime slot mean we will see less of Cody? I mean, he’ll be out clubbing by then won’t he? (I can only hope.)

  24. wcw commented on Jun 9

    I dish with the best, but never trade on anecdote. So, some actual data. In re price disinflation at the payment level, here’s a chart (please click through) of the mortgage you’d pay if you took a national-average fixed mortgage on a national-average-price home.

    No disinflation in payments is evident.

    However, if you divide the payment into the median income for families of four from the Census (NB, I had to fudge 2005 and 2006), your chart looks like this.

    Payments on index-price homes at index-rate mortgages have started to eat up family income at historically high rates. It’s all back of the envelope stuff, but this comports with my understanding of the marketplace from other data sources.

    Worth considering.

  25. douglas commented on Jun 9

    Rents aren’t going anywhere. Just look at rental vacancy and home owner vacancy numbers.

  26. JS commented on Jun 9


    BLS justifies OER as follows: “Until the early 1980s, the CPI used what is called the asset price method to measure the change in the costs of owner-occupied housing. The asset price method treats the purchase of an asset, such as a house, as it does the purchase of any consumer good. Because the asset price method can lead to inappropriate results for goods that are purchased largely for investment reasons, the CPI implemented the rental equivalence approach to measuring price change for owner-occupied housing.”

    You can read the basics about OER here:

  27. dumbfounded commented on Jun 9

    Brad deLong’s post is worth a read. When purchasing a house, price is basically irrelevant. The main factor is what is the cost of servicing the debt. Unless you’re a gazillionaire, you don’t pay cash for a house (other than a downpayment, which generally doesn’t exceed 20%). So when housing prices are up, and interest rates are down, monthly cost to the consumer can be the same.

  28. Groove commented on Jun 9


    Your data is correct, I’m sure, but real estate is local. Here there is actually disinflationary housing (on a 10-year basis), even though it has been a great time to own a home. There are areas where people are overpaying and areas where housing is cheap, just as there always is.

  29. wcw commented on Jun 9

    Indeed: location, location, location. Nobody disputed your veracity. However, on the national scale that affects my investments, at 06Q1 the payment of an index-rate fixed mortgage had almost exactly doubled since 04Q1. It would appear that your experience, where payments on a thirty-year mortgage are “virtually flat” is the exception, not the rule.

    That’s all I or any of the rest (unless I missed a comment) wanted to say.

  30. Lord commented on Jun 9

    It will vary by location. Coastal zone areas had little construction as they were already built up. In these areas rents will rise. Interior flatland areas had a fair amount of building and rents may be flat or even fall with the price of housing.

  31. wcw commented on Jun 9

    ..typo, apologies: since 94Q1, mirroring your twelve-year holding period.

  32. Groove commented on Jun 9

    wcw –

    Well, it’s interesting – this indicates to me that it’s not the labor and materials that have caused housing prices to get out of hand in areas, but rather it’s lack of supply to meet demand. Here, you can still buy/build a house pretty cheap. So it’s more of an asset bubble in areas rather than true underlying inflation – which muddies the question of whether housing is contributing to inflation.

  33. wcw commented on Jun 9

    Absolutely right. Physical and legal constrictions (read: zoning) on supply are the bugbear in most of the analysis I’ve seen. Still, the asset bubble (I like Barry’s term, “souffle” for housing; bubbles pop, souffles settle) has gone national, as I think the data indicate.

  34. Groove commented on Jun 9

    I’m not sure what the numbers on the right scale mean, but it looks like you’ve got a pretty good fit there. Assuming the scales are equivalent OER is a good proxy for house payments.

  35. wcw commented on Jun 9

    That is the BLS’s index scale, which they normalize to 100 for some year or another. It is a good fit over the full 20-year time frame (cf also the DeLong-thread comment from an actual BLS economist that concludes,

    we came to consensus that (1) the CPI should be measuring the price of “housing services”, not home prices, and (2) in the long run, averaged across the US, rents are a pretty good proxy for housing service prices.

    The key here is “in the long run.” In the short run, as the last few years or most especially during the residential trough starting around 1989, the two measures can diverge pretty strongly. From ’89-’93 they don’t just diverge, they go in opposite directions.

    Brad’s thread focuses more on the technical vagaries of price indexing. Like me, Barry has to make trades, and given the reliance of marginal GDP on the housing sector these last years, I’d say we care about recent divergence in a different way than a BLS economist.

  36. RP commented on Jun 9

    If dollar devaluation occurs, rents could climb nominally (and stay flat in real terms) while home prices could be flat nominally (and decline in real terms).

    I don’t even want to think about what it would mean for rents to drop nominally from here…

  37. Wcw commented on Jul 25

    Mortgages and income

    NB – originally posted 20060718

    Inspired by Barry Ritholtz’s discourse on owners’ equivalent rent and inflation, I ran some numbers. Above a chart from 1986 of the mortgage payment for a national average fixed mortgage on a national average price home

  38. Andrew commented on Dec 6

    my house requires major repair work, I’ve been thinking of renting while it’s being done, but I really don’t want to rent from someone who is on the road to bankruptcy and foreclosure. And after the homes are foreclosed and in the hands of the banks? I’ve never heard of banks renting foreclosed real estate.

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