What's Wrong with the CPI

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Includes: AGG, DIA
by: Don Fishback

So what’s in the table that contains numbers so consistent that they look like numbers from a Bernie Madoff account statement? No, it’s not trading data at all. It’s the annual price change of the home-owning component of the Consumer Price Index, which currently comprises about 24% of the index.

Year % Change
1 3%
2 4%
3 4%
4 2%
5 2%
6 2%
7 4%
8 3%
9 2%

Now when I say home-owning component, I am not talking about insurance, repairs and utilities. I am talking about the input that goes into CPI that accounts for purchasing a home.

You see, the technocrats in the government use what’s called “owners’ equivalent rent“. Prior to 1983, the government used actual sales data to come up with the housing component. But then things changed.

Here’s the key takeaway from the BLS explanation found at the link:

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.

Whatever. All I know is that by using the owners’ equivalent rent, inflation was grossly underestimated from 2002 to 2006. For instance, the 12-month average of the Case Shiller Index in Los Angeles in 2002 was 132.47. In 2006, it was 271.33. That’s a gain of more than 100%. And, coincidentally, it’s about the same price increase in the gold stock index XAU during that time frame. Meanwhile, the owners’ equivalent rent for Los Angeles and surrounding counties went from 211.5 to 259.9, an increase of 22.8%.(*)

That’s off by a factor of 4. And it’s a gross underestimation of what house prices did during the bubble.

But that’s not the punch line. We all know what house prices are doing. I mean, even the clueless politicians in Washington know what house prices are doing … well, apparently not everybody in Washington. According to the bean counters in Washington, owner’s equivalent rent is rising! That’s right … RISING!

The Case Shiller Home Price Index for the 20 largest metro areas peaked at 206.52 in July 2006. As of November, it was 154.59. That’s a decline of 25%. During the same time period, the home price input into the CPI calculation is UP +6%. You read that right. According to BLS, the owner’s equivalent rent is UP during the worst housing depression in this country since the Great Depression.

Here’s a graph comparing BLS data to Case-Shiller. (Click to enlarge)

IMAGE OER Is Deflation Understated by CPI?

Now, considering that this one component comprises about 24% of the entire CPI, it doesn’t take a rocket scientist to figure out that, if CPI was using actual house price data instead of owners’ equivalent rent, we’d be witnessing extreme deflation. Take that into account when you read headlines like this:

January rise in consumer prices largest since July

* For most geographic regions, BLS only supplies annual data, which is the average of each month’s reading. To make a proper comparison of this data, we have to take the 12-month average of the Case Schiller Index for each city.