Thursday, September 14, 2017

Housing, Inflation and the Cost of Living

I came across a couple of really good articles over the last couple of days on the subject of housing, inflation and GDP that I wanted to share (jump to the end for a summary of both articles).

First, the treatment of housing in the construction of the Consumer Price Index, which is commonly used to measure inflation (excerpt):

Headline inflation measures shouldn’t ignore costs of home ownership
Mojmir Hampl, Tomas Havranek 12 September 2017

Statistical offices of many countries measure the costs of home ownership by computing imputed rents, which are then included in headline inflation measures. This is the case for the US, Japan, and Switzerland, among others. In contrast, the harmonised index of consumer prices (HICP) – the EU’s most important inflation statistic – excludes owner-occupied housing, for the technical reason that imputed transactions are inconsistent with the definition of the HICP, and a more complex approach based on net acquisitions would be required (Eurostat 2012, 2013).….

…Because house purchases involve a substantial investment component, their inclusion in headline inflation makes many statisticians uneasy. Conceptually, however, homes are a special case of durable goods, because they provide a claim on a stream of future services. Cecchetti (2007), for example, showed the long-term capital gain from home ownership is very small….

…House prices are typically excluded from official inflation measures, although other goods that also provide a flow of future services (durables such as motor vehicles and washing machines) are included. There is no clear theoretical reason beyond intuition and convenience for this convention. The argument in favour is that for houses, the investment component relative to the consumption component is larger than for durables such as cars. Also, a portion of the value, such as land, does not depreciate, and is therefore often considered a good store of value.

Anecdotal evidence, however, suggests that many households treat at least their first home purchase more as consumption than investment. And theoretically, the prices of all assets, including houses, stocks, and bonds, should in principle be included in inflation if we are to measure the current cost of expected lifetime consumption, instead of merely current consumption (Alchian and Klein 1973).

Aside from the well-known studies by Alchian and Klein (1973) and Goodhart (2001), many other authors have argued for the inclusion of house prices in the consumer price index. For example, Bryan et al. (2002) showed that, in the US, the omission of house prices introduces an excluded goods bias, and results in underestimation of CPI by about 0.25 percentage points annually. Diewert and Nakamura (2009) also pointed to the need for a more direct measure of house price inflation in the official CPI index. They suggested that the recent period of low official inflation may be a mismeasurement of underlying consumer prices.

Another aspect to the "housing as investment"/"housing as consumption" dichotomy is how housing is treated in the national accounts (excerpt):

Did you know housing gets counted twice in GDP?
By Dr Cameron Murray

The argument to include both housing construction (as a new capital investment good) and housing occupancy (as a consumption good) arises from a conceptual trick at the heart of national accounting. That trick is to separate out two types of ‘final’ goods when adding up the ‘value-added’ in the economy, which is what GDP does.

One good is a consumption good. These are goods (and services) that households consume, like clothes, food, entertainment, and so forth. All the value added at intermediate stages in the production chain of these goods can be captured by looking only at the final retail value of the goods. That value represents the total value-added across the economy to produce that good.

The other type of good is an investment good. This is a good that lasts a long time and contributes to future production. A new rail line, for example, is classified a new investment good, and the value of its production is counted in GDP, even though households don’t get any value from it until it is used to run trains.

Once the rail line is being used to run trains, the value of those travel services is also counted in GDP as a consumption good, which will include within it the value contribution of the rail line itself. Thus there is a type of double-counting when it comes to investment goods — you count them when they are made, and you count them again when they are used to make consumption goods.

This is intentional. The production of investment goods is a large share of GDP — between 20 and 40% in most countries. By ignoring this production, which is also the more volatile part of production over the business cycle, GDP loses much of its value as a measure of how economically active a country is.

The construction of new homes is, therefore, an investment good, which gets counted in GDP. But then the occupancy of these same homes gets counted gain as a consumption ‘home rental’ good each period after. This applies to the 70% of households (in Australia at least) who own their own home, not just the renters. Although they don’t pay themselves rent to occupy their home, GDP is calculated as if they do by ‘imputing’ the rent that homeowners would have to pay themselves if they instead rented their home.

Ok, here's the TL:DR version:

  1. Housing is treated as both an investment as well as a consumption good.
  2. In accounting terms, it’s therefore both a balance sheet item as well as an income/expenditure item.
  3. The purchase of housing consitutes capital expenditure, while living in a house is considerd the consumption of housing services.
  4. The consumption aspect of housing is estimated using rentals. For those who own their homes, you are assumed to be paying rent to yourself. This figure is included in the inflation numbers, as well as in the private consumption category under GDP. As a side note, it’s also part of the estimation of household income, which is one reason why the official stats diverges from the man-on-the-street understanding.
  5. Mortgage costs however, are taken to be a capital expenditure, and are thus NOT included in the CPI. However, house purchases are considered as a part of investment in the national accounts, and are included under the gross fixed capital formation numbers within GDP.
  6. The CPI therefore is NOT a cost of living index, as it doesn’t include the largest capital investment most people make in their lives. It is merely an index of the price of (current) consumption, which to be fair is all it claims to be.
  7. GDP on the other hand includes housing under both investment and consumption.
  8. There’s a fundamental double standard here, as many other types of investment goods (such as cars) are not treated the same way, while other are. An especially striking example of the inconsistent treatment of investment is education, which is an investment in human capital and adds to future productive capacity, but is treated as an expense under both CPI as well as GDP (don’t get me started on the treatment of military hardware).

I’ll leave that as it is, as I certainly have no thoughts on how to best resolve these conundrums. I’ve known about both these issues for a while now, but I’ll leave the solutions to the experts.

Just bear in mind that the construction of official statistics has quirks that are vital to know when analysing and interpreting them. For example, 15%-20% of private consumption is imputed rent, and growth here doesn’t imply growth in the flows of nominal or even real incomes or spending.


  1. DR Hisham..any comment about EPF invest in USA??

    1. @Living Seed

      No comment on that. That would contravene the code of conduct I put up:

      ...and my boss might just have my head for breakfast.

  2. Hisham, Thanks for the blog.
    I have one question.
    Just wondering if Malaysia Consumer price index numbers use any hedonic quality adjustments? Just a crude example that may not be reflective of the way it is done: If a new TV model is double the size but is sold at the same price compared to the old model they will make a downward price adjustments to reflect this even if you are unable to buy the previous model at a lower price.

    I understand that they use this in the US and it likely biases inflation downwards.

    1. @anon

      AFAIK, the Malaysian CPI doesn't include hedonic adjustment.

      In any case, hedonic adjustments tends to bias inflation measurement upwards, not downwards, because typically the adjustment doesn't fully adjust the CPI for quality differences.