How Owner's Equivalent Rent Duped the Fed

Those of you who remember "Homeownership Costs and Core Inflation" from almost two years ago may be interested in seeing how the relationship between these two has developed since that time.

Recall that the crux of the issue, then as now, is the use of OER (owners' equivalent rent) to represent home prices in the CPI (Consumer Price Index) and the distortions that arise as a result - OER is one of the poorest proxies the world has ever seen as demonstrated by the comparison below with the Case Shiller Home Price Index.

As you can see, the year-over-year change in home prices has gone from almost 20 percent a few years ago to low single-digit negative numbers just a couple months ago. During this time OER has remained flat by comparison, effectively taking home prices out of the consumer price statistics.

So, what would happen to the consumer price index if real home prices were substituted for the much maligned OER?

You will see in a minute.

Keep in mind that the charts that follow are a simple substitution of Case Shiller home prices for OER and no attempt is made to include other important factors in homeownership costs, something that OER purportedly does. These other factors would include such items as prevailing interest rates, available mortgage products, property taxes, insurance, and the like.

A full-time economist at the Federal Reserve could extend these charts into a more proper analysis including a myriad of factors to arrive at a true representation of housing costs in the consumer price index and they would probably arrive at similar conclusions.

Given what's now happening in the housing market now and who's getting much of the blame, it may be in their best interests to get out "ahead of the curve" on this if it is their desire to continue as an institution - the calls for the abolishment of the Federal Reserve or a major overhaul regarding how they do business have become louder and more frequent as the housing mess continues to unfold.

And any economist who argues that OER better captures the "utility" component of housing or nonsense such as this, please, just stop it!

You've gotten us into enough trouble as it by ignoring home prices.

A Misleading Headline

So, the first chart is the overall consumer price index with the Case-Shiller Home Price Index substituted for owners' equivalent rent.

Two areas of the chart are important. First, in early 2002, when the Fed was worried about "deflation", home prices were increasing at a healthy pace and had they been included in the CPI, it would have fallen to only two percent instead of one percent. The "deflation scare" wouldn't have been so scary.

Second, in early 2004, while the Fed funds rate was still only one percent, home prices began to take off - the CPI would have been over seven percent using the Case-Shiller data instead of only about three percent with OER.

In summary, the Greenspan Fed didn't have to take rates as low as they did or leave them there that long.

Home prices were booming during this time and if they were properly accounted for in consumer prices, monetary policy would not have become too easy and stayed that way for too long - what an increasing number of observers are citing as the genesis of the current housing problems.

Trouble at the Core

Next is the Fed's preferred measure of inflation, core inflation, where food and energy prices are stripped out. For the overall CPI, owners' equivalent rent contributes 23 percent to the total index, but for core inflation, this goes up to 29 percent. Look what happens if that same simple substitution is performed for the core rate of inflation.

Here too, there are two important points. First, core inflation since the turn of the century that includes real home prices comes nowhere close to the magical two percent level targeted by the Fed - it averages closer to five percent when the Case Shiller data is used.

And, more importantly, the housing "deflation" that has recently arrived on the nation's doorstep would drive core CPI to nearly zero. This is much closer to outright deflation than the level of overall inflation that terrified the Fed back in 2002 - this is pretty close to Japan-style inflation.

If core inflation as presently calculated by the Bureau of Labor Statistics were to round to zero with a trajectory such as the one seen above, you'd bet that the Fed would be all hot and bothered, already slashing short-term rates with abandon.

When home price deflation is added to the consumer price calculation, it would appear that not slashing interest rates today is as big a blunder as what Alan Greenspan did earlier in the decade.