The New York Times

June 26, 2005

How Home Prices Can Be Hot but Inflation Cool


ANYBODY who has bought or sold a home recently - or who has picked up a newspaper - knows that housing prices are rising rapidly. The National Association of Realtors projects that the median sales price of an existing home will rise 8.8 percent this year, after climbing 8.3 percent in 2004.

Yet the Bureau of Labor Statistics, the government agency that collects, mixes and distills data into the Consumer Price Index, says the increase in housing costs has been muted. The index, the broadest measure of inflation for consumer activity, shows that housing costs rose just 0.1 percent in May and 3 percent in the last 12 months. That begs a question: When housing is the biggest single expenditure for most Americans, and when half of the nation is fretting about a housing bubble and the other half is logging on to, how can inflation remain tame?

The answer has to do with the occasionally strange way the government produces the numbers that define our economic life - numbers on which vast sums are wagered every day.

Until 1983, the bureau measured housing inflation by looking at what it cost to buy and own homes, considering factors like house prices, mortgage interest costs and property taxes. But given the shifts in interest rates and housing prices, those measures could show big bounces from month to month. Besides, homes are a strange hybrid of a consumable good and a long-term investment. As part of a long-running evaluation, the bureau wanted to "separate out the investment component from the consumption component" of the housing market, said Patrick C. Jackman, an economist at the bureau.

In other words, a home isn't just where you hang your hat or an investment in the future (or, in the case of visitors to, for two days). It's something that is consumed, the way potato chips, gasoline or a barber's skills are. So the bureau decided to track a measure that represents only the consumption of housing: rent. And rents had much to recommend themselves as a long-term inflationary yardstick - they don't jump significantly from month to month - and as a proxy for home prices. Over time, after all, rents correlated very closely to home prices.

"It's important to separate the decision that people make about housing as an investment and housing as a consumption of services," said Ted Wieseman, an economist at Morgan Stanley. Especially when you're trying to measure inflation. Consider the Standard & Poor's 500-stock index: it cost three times as much to buy it in 2000 than it did in 1992. But that climb didn't signify rampant inflation in the United States. The Bureau of Labor Statistics is trying to measure consumer price inflation, not asset price inflation.

So, for the past 22 years, it has measured inflation in the cost of housing in a rather indirect way. As part of its Consumer Expenditure Survey, the bureau collects information from thousands of Americans about how much they pay for rent. But because renters are only a small part of the population, it also tries to measure how much homeowners are essentially paying themselves in rent. To determine the so-called owners' equivalent rent, it asks homeowners how much they would have to pay to rent the house in which they live. That figure constitutes about 23.2 percent of the Consumer Price Index, by far its largest component. Food is 14.3 percent and transportation is 17.4 percent, for example.

But there are a few problems with using owners' equivalent rent as a measure of inflation for shelter costs. First, rent and home prices have become decoupled over the last several years, as Richard J. Rosen, an economist who is an adviser to the Chicago Federal Reserve, has observed. In the last 12 months, owners' equivalent rent has risen only by 2.3 percent, while housing prices have risen by a much larger amount.

"Of course, some of this decoupling has been a response to the low mortgage rates," Mr. Rosen said, adding that it was an open question whether it signaled an enduring disconnection between rents and home prices.

Second, years of falling interest rates and the vast expansion of the mortgage industry have changed the historical dynamics between renting and owning. From 1994 to 2004, the percentage of home-owning households rose to 69.2 percent from 64.2 percent, according to the Census Bureau. What's the point of measuring rents if fewer and fewer people are actually renting?

Finally, shifts in Americans' relative desire to own rather than rent can play havoc with inflation measures. Rising home prices - and rising interest in owning homes - have helped to keep housing rents in check in recent years. So even though the rampant housing market is forcing home buyers to cough up more of their income for the same amount of shelter, the comparatively soft rental market is holding down inflation as measured by the Consumer Price Index.

CONVERSELY, when housing prices fall, a trend that most people would deem anti-inflationary, and renting becomes more attractive than owning, the index might process the information as evidence that inflation is on the rise. "We got a great deal of criticism that we were overstating inflation in the early 1990's, because housing prices were declining and rents were going up steadily," Mr. Jackman said.

The housing market today is a polarizing force. On one side are those who are convinced that the market is a bubble about to pop. On the other side are those who believe that we are in the midst of a long-term boom. But at the Bureau of Labor Statistics, Mr. Jackman notes, "We're pretty much conditioned to be in the middle."

Daniel Gross writes the "Moneybox" column for