"Why the government took home prices out of its main inflation index"

From Full Stack Economics, May 11, 2022:

A 1983 change reduced volatility but probably didn't lower the average inflation rate.

The official inflation rate in March 2022 was 8.5 percent—the highest level in 40 years. But some people suspect the true figure was much higher.

The example that comes up most often is housing. Critics point back to the early 1980s, when the Bureau of Labor Statistics (BLS) made a fundamental shift in the way it calculates the consumer price index (CPI) for shelter.

Previously, the inflation rate for owner-occupied homes was calculated based on actual spending by homeowners: the purchase price of the home, mortgage interest payments, property taxes, and so forth. In 1983, the BLS switched to a new method called owners’ equivalent rent. The agency started estimating how much the homeowner would have paid if they were renting their home from a hypothetical landlord.

This methodological innovation understandably sets off alarm bells among people who are predisposed to distrust the government.

For example, in an article for National Review last December, the investment banker William Levin criticized the rental-equivalence approach used in the CPI, calling it “absurdly subjective and unscientific.”

Last week, in the newsletter Common Sense, Samuel Gregg suggested that the government excluded home prices from the CPI in order to “massage the inflation number down.”

Critiques like this invariably assume the switch to owners’ equivalent rent has systematically lowered the measured inflation rate. But is that really true? When I (Tim) started working on this story, I thought it would be straightforward to check. But I discovered that even most experts didn’t know the details of the old BLS approach.

So I recruited my co-author Aden to help me figure it out. Aden dug deep into the archives of the Bureau of Labor Statistics to figure out exactly how the agency calculated inflation prior to 1983. Eventually, he found a little-noticed chart in an economics paper that reconstructed the index through 2018. The paper’s authors shared their code with us, allowing us to extend their calculation through February 2022.

After doing this research, we believe the critics of current BLS methodology are partly right and partly wrong. Today’s annual inflation rate likely would be a few percentage points higher if the BLS were still using its pre-1983 methodology for shelter inflation. But it’s not true, as many people claim, that the switch led to systematic understatement of the inflation rate over the last 40 years.

“We didn’t find that inflation was on average higher or lower with the old method,” said economist Jonathan Hazell, one of the paper's authors. “Rather, it was more volatile for reasons that didn’t make much sense to us.”

The old methodology didn’t just include home prices, it also included mortgage interest payments. And while home prices have risen rapidly since 1983, mortgage interest rates have plunged over the same period.

Low mortgage rates have made homeownership more affordable

Almost everyone finances home purchases with long-term borrowing. As a result, the cost of owning a home depends not only on the price of the home, but also on mortgage interest rates at the time of purchase. And this creates a challenge for government statisticians.

Suppose you buy a home for $500,000, financing the purchase with a mortgage at a 6.4 percent interest rate. A few years later, you sell for $600,000. Interest rates have fallen, and the new buyer is able to get a mortgage at 4.7 percent.

The price of the home has risen by 20 percent, so you could just say the cost of housing has gone up 20 percent.  But that would be misleading. Assuming a 20 percent down payment, your original mortgage would have cost $2,502 per month, while the new owner’s mortgage would cost $2,489 per month. The monthly mortgage payment required to own the home actually went down.

This isn’t just a theoretical possibility. Over the last 39 years, inflation-adjusted home prices have almost doubled. But mortgage interest rates plunged from 13 percent in 1983 to around 4 percent in the first quarter of 2022. As a result, a typical mortgage payment in the first quarter of 2022 was 25 percent lower, in inflation-adjusted terms, than the mortgage on the same home would have been in 1983....

....MUCH MORE