Do Central Bankers Care About Rising House Prices?

Why don’t central bankers care about rising asset prices?
For most people their greatest expense is housing. According to the Bureau of Labor Statistics, Americans spend almost 40% of their take home pay on shelter, this might lead you to ask - why aren’t home prices included in measures of inflation? And should they be?  Is real inflation much higher than is being reported in the CPI because of asset price inflation?

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Transcript

For most people their greatest expense is housing.  If you are a millennial, its probably avocado toast, but right after that housing.  According to the Bureau of labour statistics, Americains spend almost 40% of their take home pay on shelter, this might lead you to ask - why aren’t home prices included in measures of inflation? And should they be?
Inflation (as I’m sure you know) is a measurement of changes in the overall price level of goods and services throughout the economy. It is measured by comparing the current prices of a representative basket of goods and services to their previous prices. That (so far) sounds pretty simple, but it turns out to be a bit more complicated than you might expect. 
The Consumer Price Index (or CPI), is the most widely used measure of inflation. It is designed to measure price changes faced by urban consumers and is representative of the inflation experienced by 93% of the U.S. population. It is an average, though, and doesn’t necessarily reflect your specific experience.  We’ll come back to this idea near the end of the video and discuss how your experience of inflation might differ significantly from the CPI.
Now, we’ve seen huge government stimulus over the last year and a half relating to the global pandemic, and this has brought about the broadest global house price boom in over twenty years according to the Financial Times. It has also pushed up all sorts of other asset prices, things like stocks, bonds, classic cars, crypto currencies, even blue chip stocks like AMC and Gamestop. A lot of commentators are arguing that there is way more inflation occuring than shows up in the CPI, you just need to take asset price inflation into account. They argue that if central banks have a mandate to maintain price stability.  Shouldn’t home prices and the stock market be included in their measures of inflation?
The government of New Zealand might even agree with this idea.  Six months ago New Zealands government formally instructed their Central Bank to consider housing prices in making monetary policy decisions. We will discuss what this means in just a moment.
But, first up, why are home prices and other financial asset prices excluded from inflation calculations?
Well, they weren’t always, up until 1983, in the United States, the CPI actually included home prices. The index was changed because inflation is supposed to be a measure of the cost of buying goods and services for consumption today.  While a home might be your largest purchase, it is an asset that is not entirely consumed like other purchases – so buying a house is a mix of investment and consumption.  Other investments like stocks bonds and gold are excluded for the same reason, they are not consumption assets.  
Now, you might argue that things like cars and refrigerators, that yield services over several years are included in the inflation basket, and this is true, but the big difference is that these items depreciate much faster than houses do and thus the difference between the value of the services consumed and the price paid is much less extreme.
It could be argued that if you did no repairs to a house that it would lose much of its value over time. This too is true, and for this reason the cost of home maintaininence finds its way into most calculations of inflation globally.
So is the price of housing completely ignored in inflation figures? No, in fact it is one of the most important costs that go into the calculation. Shelter-costs account for around a third of the overall CPI, but instead of the cost of buying a home, the change in rental equivalence goes into the calculation. How it works is that the BLS looks at your home, they try to estimate how much you’d have to pay to rent it, and they count changes in that amount in the inflation numbers. This “rental equivalence” method was adopted by the UK too starting in 2017.
The way they see it, housing is a service and almost everyone is purchasing that service from a landlord. If you own your own home, they view you as being your own landlord. Now, in a country where most people are renters, this might appear to make more sense, but 65% of Americans own their own homes and 63% of British people do too. So, does it make sense that one of the main items in the consumer price index is rent, a price that most people don’t pay.
Well, the BLS argue that this rental cost is a much better estimate of the consumption portion of housing services, even though rent pricing trends often differ significantly from house price trends. 
The idea is that when house prices go up, if this increase is permanent it should feed into inflation, since rents usually go up too. But in situations where house prices go up a lot more than rents do, then only the rental cost should be counted in inflation. This is because the “extra” house price increase (the bit that is unrelated to rent) is more of a financial asset gain it is not linked to the ongoing cost of getting to live indoors.  When people pay more for a house than might make sense based upon the rent it would generate, they’re speculating that rents will increase in the future. The actual cost of living in the house has not changed, but the cost of a real estate investment has. 
If you think about why we care about inflation at all. You can see why the BLS counts rent equivalence rather than home sales prices in inflation. This isn’t just an American and British thing, rent equivalence is the most common method used to measure changes in the cost of shelter globally -  13 out of 30 OECD nations use this method. The next most common method is for a nation to entirely omit shelter from the CPI calculation.
Now, the European Central Bank does not use this method, they prefer a “net acquisitions” method which aims to measure the changing price of purchasing homes but not the land on which the homes are built. It is worth noting that they are struggling with how to break house price changes down into the physical structure and the land value.
In Sweden, the Central Bank includes actual mortgage payments in their inflation calculation. Mortgage payments of course relate directly to interest rates, and this means that hiking interest rates in order to reduce inflation will actually cause inflation when you use a measure that is constructed this way. The main tool that central banks have for dampening inflation is adjusting interest rates, and the investment portion of housing prices is extremely interest rate sensitive.
OK, so, Does the fact that asset prices are excluded from inflation calculations mean that central bankers don’t care about how their policy changes will affect house prices and stock prices?  Absolutely not, it just means that they don’t consider these price changes inflation.  Central banks do (fairly obviously) care about asset prices and pay attention to them. As you can see over the last year, central banks have been working overtime to stabilize asset prices (which include stocks, bonds and real estate).  You can in fact make a good argument that they should pay less attention to these prices.  So, they do pay attention to these price changes, they just don’t classify increases in these assets prices as inflation because these items relate to savings and not to day-to-day consumption expenses.
Ben Bernanke has argued that changes in asset prices should only affect monetary policy to the extent that these price changes affect the central banks forecast of inflation.  It’s not the role of a central bank to decide the fair value of a house or of a share of Tesla.  These things only become a concern to them when sustained price rises could become inflationary.  
Eric Rosengren, the president of the Federal Reserve Bank of Boston told the Financial Times last June that “It’s very important for us to get back to our two per cent inflation target but the goal is for that to be sustainable,”, “In order for that to be sustainable, (he said) we can’t have a boom-and-bust cycle in something like real estate.  He finished up by saying that “it’s worth paying close attention to what’s happening in the housing market.”
OK – enough with theory and explanations… We need to ask some hard questions…
Did the BLS in the United States, and later the ONS in the UK adopt the rental equivalence method simply to lower the measured rate of inflation?
Well in the US, when rental equivalence was first introduced in 1983, it actually increased the reported rate of inflation. According to the National Association of Realtors, between 1983 and 2007 the monthly principal and interest payment required to purchase a home in the United States rose by 79 percent, much less than the rental equivalence increase of 140 percent over that same period.
Looking at UK data, you can see that different approaches produce differing results. The net acquisitions method (favored by the ECB) shows the greatest increase in housing costs, and the out-of-pocket payments approach (which takes both house prices and mortgage interest rates into account to determine the monthly cash payments associated with home ownership) will have experienced the lowest inflation.  Rental equivalence sits in the middle of those two.  
That out-of-pocket expenses approach, which the UK used to use to calculate the (now defunct) retail price index would have actually reduced inflation over the fifteen year period because interest rate cuts since the financial crisis have brought mortgage costs to historic lows.
OK, so the next hard question is - should central banking mandates change?  Should the rest of the world follow New Zealand’s example and require central banks to assess the effects of their monetary policy decisions on the government’s objective of supporting more sustainable house prices.
Well, the central bank of New Zealand (after having their mandate changed) went on to define sustainable house prices as being house prices that are not obviously in a bubble.  They argue that structural factors in New Zealand, such as urban planning rules, land use restrictions, population growth and the current low interest rates mostly explain high house prices and thus no intervention is necessary.
When you look at New Zealand house prices, you can see that they have hugely outpaced inflation over the last 25 years, but it’s worth noting that interest rates in New Zealand were around 10% in 1995 and are around a quarter of a percent today.  Falling interest rates can be expected to push up real estate prices – the less a buyer spends on mortgage interest, the more they can afford to pay for a house.
Other governments seeking a quick fix to the problem of rising housing costs face the same dilemma: pushing up interest rates, in order to control house prices risks fueling unemployment and depressing living standards, thereby undermining financial stability. So, governments and central banks will most likely continue to worry about affordability — but with very limited ability to tackle it.
Finally, let’s discuss the issue of inflation inequality, or why your experience of inflation might be different to what is measured by the CPI. 
The CPI is specifically designed to reflect the spending patterns of urban consumers, urban wage earners and clerical workers. So, if you live in a rural or suburban area, work on a farm, are in the armed forces or (are in prison or a mental institution), your experienced cost of living changes may be quite different to what is measured by the CPI.  The BLS is quite clear about that on their website.
Most of the differences in experienced inflation can be traced to changes in the relative prices of education, health care, and gasoline. The elderly will have experienced higher inflation than average, mostly due to their higher health care expenditures.  Young people (or those paying University fees) in the United States will have experienced higher than average inflation, as US university fee increases have far outpaced inflation. Low-income households, and non-urban households tend to be more sensitive to fluctuations in fuel prices, as this expense makes up a larger proportion of their expenditures, than is reflected in CPI.
Over the last year, there has been a trend of people moving out of major cities to the suburbs, this has kept urban rents (which are included in CPI) down.  Suburban rents and home prices have been rising and these are not reflected in the CPI. Let me know in the comments section if you think your realized inflation has been higher or lower than the official figures over the last year and why?
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