Plugging the Hole in the UK and Eurozone Inflation Targets

The price indices used to define the UK inflation target (2 percent per annum) and the inflation rate deemed consistent with price stability in the Eurozone (below but close to 2 percent per annum) are a disgrace. They make sense only if the inhabitants of the UK and the Eurozone are homeless and sleep under bridges. The reason is that there is no component in the Harmonised Index of Consumer Prices (HICP) used to define the operational inflation targets in the UK and in Euroland, that tries to capture housing cost inflation.

Let me start by saying that I hold the view that the price index used to define the operational inflation target should be the best possible practical approximation to the cost-of-living-index of Mr & Ms Average and the rest of their nuclear family. I know that in Euroland, the statistical experts that control Eurostat deny that the HICP is or should try to be a cost-of-living-index. They are wrong. If the price index defining the central bank’s inflation target does not try to approximate a representative cost-of- living-index, it is useless and should be discarded.

The housing cost measure that should enter the price index is clear in principle: it is the actual rental cost (of people living in rented accommodation) or the imputed ‘shadow rental cost’ for owner-occupiers – what economists call the ‘user cost’ of housing capital. This market or shadow price of the flow of housing services is quite distinct from the price of a house. If markets function properly, the price of the house is the present discounted value of the future rental cost of the house, using the appropriate risk-adjusted discount rates. Measuring housing cost inflation is difficult when the housing rental market is heavily regulated, distorted, price-controlled, publicly owned and/or unrepresentative of the housing cost experience of a large part or even most of the population. Such is certainly the case in the UK.

The response of the Eurostat statisticians to the problem of getting a reasonable measurable proxy for the true shadow rentals of the housing stock - one that has to be comparable across the 13 (soon to be 15) countries of the Eurozone - has been to exclude housing costs from the Eurozone HICP index altogether. This amounts to the assumption that the inflation rate of housing costs is the same as the inflation rate of the rest of the price index. Whatever the merits of this assumption for the Eurozone (in Spain and Ireland it grossly underestimates true housing cost inflation; in Germany it may well overstate it), the assumption that housing cost inflation is the same as the inflation for the rest of the UK consumer price index (CPI) is a howler. With housing costs probably around a quarter of the median household's budget, and with housing cost inflation outstripping CPI inflation year after year, using the CPI to define the inflation target is becoming as much of an embarrassment in the UK for the MPC - and, a fortiori for the Chancellor, who is responsible for this state of affairs - as the Fed's obsession with core inflation is becoming a source of embarrassment for the FOMC.

Any reasonable estimate of the UK housing costs have been rising much faster than the CPI for many years in most of the UK. As the Chart below shows, the UK Retail Price Indices, both the all-inclusive RPI and the Bank of England’s old inflation target index, RPIX (RPI exclusive of mortgage interest payments but inclusive of some other, admittedly unsatisfactory, proxies for the cost of housing services) have been showing rates of inflation well above that for the CPI since early 2003, when the UK housing market went into overdrive. There are technical reasons other than the omission of housing costs from the CPI why the RPI and RPIX tend to show higher inflation than the CPI: even with constant nominal interest rates and housing inflation at the same rate as the inflation rate in the rest of the economy, RPI and RPIX inflation tend to exceed CPI inflation by between 0.50% and 0.75% per annum (for the inflation rates observed since the early 1990s). But the gap is big enough to matter economically and politically.

The user cost of housing during a year (what you would have to pay in a competitive market to rent the house for that year) can be approximated as the product of the price of the house at the beginning of the year and the sum of four terms. These are: (1) the risk-free rate of interest for that year, (2) the risk premium on housing, (3) the depreciation rate of the housing stock and (4) minus the percentage capital gains on the house over the year (taxes paid by tenants, like the UK’s Council Tax, must also be included).

Of these four key inputs in the calculation of the consumer’s cost of housing services, the second, the risk premium on housing, is unobservable, but possible proxies can be thought of, including the equity risk premium for property companies and similar observable risk premia. Alternatively this user cost estimate could be combined with sample evidence on actual rents paid in that part of the UK residential rental market that is reasonably competitive.

It is not beyond the wit of the National Statistical Office to come up with a monthly estimate of the consumer’s cost of housing services that could be included in the UK’s CPI right now. It will be imperfect, but it is bound to be better than the blatantly systematically incorrect assumption that is currently made – that housing cost inflation is the same as the inflation rate of the rest of the CPI.

Euroland may have to move at the pace of its slowest member state when it comes to including a housing cost component it its HICP index. The UK is not constrained by that. The case for moving swiftly is strong. Inflation targeting by the Bank of England will be discredited if, when the Bank achieves its 2 percent CPI mandate, everyone who can walk and chew gum knows that the true rate of inflation, which includes housing costs, is significantly above 2 percent. So what are we waiting for? It is better to be approximately right than precisely wrong.