Truck and Barter: The CPI does NOT Measure Prices

June 09, 2005

The CPI does NOT Measure Prices

By Kevin

Because the cost of housing is imputed through housing rental markets, and because hedonic regression quality-change adjustment, the CPI is now alleged to understate inflation:

Home prices in the Washington area have doubled or tripled in many neighborhoods, and the cost of maintaining, heating, cooling and improving homes also has been soaring....
Yet the department's housing cost index rose only by 2.7 percent in the past year — a discrepancy that has economists scratching their heads.
"The core CPI considerably misrepresents what is happening in the housing market," said John Silvia, chief economist at Wachovia Securities, who added it's "time to can the core."
The problem with the housing index, economists say, is it does not measure the cost of owning a home but rather reflects the cost of renting, which has been rising much more slowly than the cost of home purchases and upkeep.

If you believe that the CPI is supposed to measure such a thing, then this housing argument appears right on target...

And what the BLS says about "rental equivalence" is that owners equivalent rent is approximately 22% of the total CPI, and is a sample of renters adjusted to meet the characteristics of nearby owned houses.

Clearly, when housing prices rise but rents don't there is a negative bias in OER. Similarly, when rents rise, but housing prices don't there's a positive bias in OER.

But wait a second, aren't we in a speculator-induced bubble in housing caused by low interest rates? Most people buy homes with mortgages. The monthly cost of owning a home is more than the pro-rated purchase price; it's really the size of the mortgage payment (principal and interest), utilities, and taxes. The core CPI doesn't adjust for lower interest rates and new-fangled interest-only loans either.

As Barry Ritholtz notes, lower interest rates correlate with lower owners equivalent rent through impacts on the demand for house-ownership. Barry considers this a negative bias in the CPI, but I consider this an appropriate adjustment for the lower cost of ownership due to lower interest rates.

The CPI misses the increase in prices, but it also misses the decrease in interest rates. Which is the greater impact on out of pocket costs probably depends on where you live... Compare Santa Monica, CA to Buffalo, NY... Up-to-date data on U.S. fixed and variable mortgage interest rates paid, sizes of mortgages, and sales prices can be found at the Federal Housing Finance Board.

If you haven't had enough housing price talk, you can visit the housing bubble blog.

The rest of the WaTimes article is just one big muddle about too much quality adjustment. But it never defines what the CPI measures, what is meant by "inflation", and how and why this differs from the prices people actually see.

The CPI does not measure "out of pocket" costs, and so if it is underestimating those costs, the fault really lies with the person using the data inappropriately, not with the BLS.

The point is that, yes, non-housing consumer costs are rising, but so are consumer benefits. The CPI is not measuring the change in gross cost to purchasing a thing called a television set, or a computer, or an automobile. It is measuring the change in cost net of change in benefit. It does not try to measure just the increase in the prices people pay, but also the quality and configuration of the goods people are buying.

If you want to gauge out-of-pocket costs, then perhaps you should look at data that actually tries to perform that task.

There is, of course, a very simple solution to this problem. Have the BLS produce a specalist "research" index that doesn't use hedonic indexing or quality adustment at all...

Posted at June 9, 2005 11:33 AM

Comments

There's another complicating factor. When adjusting for improving quality and configuration, there's always the situation where people wouldn't actually be demanding improved quality and configuration if not for the fact that it was mandated by law.

For instance, a car with airbags may in some sense be an improvement over a car without. But, for lots of customers, the airbag is completely worthless and the "improved" car is only being bought because the sale of cars without these improvements is forbidden. In fact, in the airbag case, a parent that would like to let her child sit in the front seat will consider a car with an airbag to be worse than a car without one!

And yet, while every car on every lot is more expensive thanks to improved "quality and configuration", these consumers are finding themselves paying more for an item that isn't any better to them, and may in fact be worse from their point of view, than the cheaper cars that are no longer available to them.

This particularly shows up in housing. Yeah, the houses that we live in are larger than the ones our parents grew up in, which in theory makes up for the fact that we're paying more for them. But, if we really wanted a smaller cheaper house, and housing restrictions say we can't have one, then we're being forced to pay more for housing that really isn't better as far as we're concerned. But to other people, it really is better, and the extra cost is worth it. Has any price inflation taken place?

Comment by Ken at June 9, 2005 03:05 PM | Permalink