Do Central Bankers Care About Rising House Prices?

Episode Summary

Executive Summary: This podcast explains why home prices are excluded from CPI (they are investment, not consumption) and how rental equivalence is used instead. It discusses central bank mandates, asset price inflation, and inflation inequality, using examples like New Zealand and historical data. The host argues that CPI may not reflect personal inflation experiences, especially for housing, and that central banks face a dilemma in balancing housing affordability with employment.

Main Topics: Why Home Prices Are Excluded from CPI (Priority: 5/5): Housing is a mix of investment and consumption; only the consumption portion (shelter services) is included. Home prices were included until 1983 in the US, then changed to rental equivalence. Rental Equivalence Method (Priority: 5/5): The BLS estimates how much it would cost to rent your home and counts changes in that amount. Used in US, UK, and 13 of 30 OECD nations. It captures the consumption of housing services, not investment gains. Alternative Inflation Measures for Housing (Priority: 4/5): Other methods include net acquisitions (ECB) and mortgage payments (Sweden). Each has different implications for measured inflation and policy responses. Central Bank Mandates and Asset Prices (Priority: 4/5): Central banks care about asset prices but do not classify them as inflation. New Zealand's mandate change to consider house prices is discussed, along with Bernanke's view that asset prices affect policy only via inflation forecasts. Inflation Inequality (Priority: 3/5): Different groups experience different inflation rates due to spending patterns (healthcare for elderly, tuition for young, fuel for low-income). The pandemic shift from urban to suburban rents may understate CPI. Historical Housing Cost Trends (Priority: 3/5): Between 1983 and 2007, principal+interest payments rose 79% vs rental equivalence 140%. Different methods yield different inflation rates, with out-of-pocket payments showing lowest inflation due to low interest rates.

Key Arguments: Housing is a mix of investment and consumption; only the consumption portion should be in CPI, hence rental equivalence is appropriate. Asset price inflation (stocks, real estate) is not the same as consumer inflation; central banks should not target asset prices directly. Changing central bank mandates (like New Zealand) may not solve housing affordability because structural factors (land use, interest rates) are the main drivers. CPI may understate inflation for certain groups (elderly, students, low-income) due to different spending patterns, and recent pandemic shifts in housing may further distort the measure. The rental equivalence method was not adopted to lower inflation; in the US it initially increased reported inflation compared to the previous method.

Data Points: Percentage of take-home pay spent on shelter: almost 40% - According to Bureau of Labour Statistics, Americans spend almost 40% of take-home pay on shelter. Homeownership rate in US and UK: 65% (US), 63% (UK) - Percentage of Americans and British who own their own homes. Shelter cost share of CPI: around a third - Shelter costs account for around a third of the overall CPI. OECD nations using rental equivalence: 13 out of 30 - Rental equivalence is the most common method globally for measuring shelter costs in CPI. Increase in principal+interest payment vs rental equivalence (1983-2007): 79% vs 140% - Monthly principal and interest payment rose 79%, rental equivalence rose 140% over that period. New Zealand interest rates in 1995 vs today: 10% (1995), 0.25% (today) - Falling interest rates have pushed up real estate prices in New Zealand.

Pivotal Quotes: "For most people, their greatest expense is housing. If you're a millennial, it's probably avocado toast, but right after that, housing." — Patrick Boyle: Opening humorous remark about housing costs and millennial stereotypes. "It's very important for us to get back to our 2% inflation target, but the goal is for that to be sustainable. In order for that to be sustainable, we can't have a boom-and-bust cycle in something like real estate." — Eric Rosengren: President of the Federal Reserve Bank of Boston, quoted in the Financial Times, on the need to avoid housing bubbles. "The extra house price increase, the bit that's unrelated to rent increases, is more of a financial asset gain. It's not linked to the ongoing cost of getting to live indoors." — Patrick Boyle: Explaining why only rental equivalence is counted in CPI, not speculative house price gains.

Implications: Listeners should understand that CPI may not reflect their personal inflation experience, especially for housing. Central banks face a dilemma: raising rates to curb house prices could hurt employment and financial stability. Inflation inequality means policy affects different groups unevenly, and recent pandemic shifts may further distort official inflation measures.