Graphic Content – July; Is US inflation really that high?

Jack Norris
Written by

13th July 2018

As the Federal Reserve progresses to the later stages of its hiking cycle, and the market is pricing for the European Central Bank (ECB) to start hiking midway through next year, it’s worth taking a step back and comparing inflation between the two economies.

Shelter, or housing, is the largest component of US Consumer Price Index (CPI), and within this bucket the largest component is Owner’s Equivalent Rent (OER) (23%), followed by ‘rent of primary residence’ as the second largest (7%). Owner’s equivalent rent is a measure which essentially uses a survey to estimate the cost (or opportunity cost) of home ownership. In this respect, it isn’t a true record of prices actually paid by consumers. The purpose for using OER is that most households in the US own the home in which they live, and so OER aims to capture the cost of home ownership that “homeowners implicitly pay to themselves or, alternatively, the amount they could obtain by renting their home to someone else” (New York Fed).

The OER measure is therefore a unique part of the US consumer price index in that it is not based on observable prices. As the largest single component accounting for a huge portion of total core inflation, it therefore seems bizarre that the methodology relies on essentially estimating what people would rent their houses out for if they could.

In other economies, housing is not included in consumer price indexes. For Eurozone inflation, the Harmonised Index of Consumer Prices (HICP) measure of inflation does not have an OER measure, but just holds a weight of 6.4% in ‘actual rentals for housing’, representing the key component in housing costs. In the UK, Consumer Price Index including Housing (CPIH) uses private sector rent changes as a proxy for the housing costs of owner-occupiers, while CPI had excluded house ownership costs entirely. Retail Price Index (RPI) included housing costs, but this measure has its own problems.

Moreover, there is disagreement by economists over whether payments for owner-occupied houses should be included in the index. If a house is a capital good, not a consumer good, then it shouldn’t be part of the consumption bucket. Then again, the argument can be made that the house itself is a consumer good which depreciates with use, while the land on which the house sits is the capital purchase and increases in value due to scarcity.

Core eurozone CPI inflation is no different from the US

Source: Societe Generale, 21 June 2018.

The chart above was created by Societe Generale, who made the comment that the ECB had been running excessively loose monetary policy, because their measure of core CPI understated inflation1. However, if we take the view that OER is an imprecise measure of housing costs, then excluding OER suggests that US core CPI is not as strong as it looked. Sure, there are different levels of slack between the US’s tight labour market and the Eurozone, but perhaps the US economy is not running as hot as it appears to be.

1 Source: Societe Generale Cross Asset Research, 21 June 2018.

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