How Inflation Data Hinges On A Statistical Quirk For Housing Costs

The U.S. inflation rate is, of course, crucial for markets today. It’s why the U.S. Federal Reserve (Fed) hiked rates extremely aggressively in 2022. In turn, slowing inflation may cause the Fed to ease rates in 2023. The statistical details of how housing costs are calculated, make falling inflation more likely in 2023.

Housing is the largest cost in the Consumer Price Index (CPI) inflation series, with a weighting of 32.7% as of November 2022, or about a third of overall inflation series. The method of calculation for housing costs in CPI as used by the Bureau of Labor Statistics (BLS) is unique.

Some argue that the method used is unhelpful, stale or simply wrong. Understanding the lag introduced by the panel approach to determine housing costs is key to determining the path for inflation in 2023, as it may create lower reported inflation as 2023 progresses.

The Calculation Of CPI Housing Costs

Here’s how Fed Chair Jerome Powell explained housing costs in inflation at a speech at the Brookings Institution on November 30, 2022:

“Housing inflation tends to lag other prices around inflation turning points, however, because of the slow rate at which the stock of rental leases turns over. The market rate on new leases is a timelier indicator of where overall housing inflation will go over the next year or so. Measures of 12-month inflation in new leases rose to nearly 20 percent during the pandemic but have been falling sharply since about midyear [2022].”

The Lag In CPI Housing Costs

Powell’s comments alludes to how housing and rental costs are calculated differently to other variables in the CPI inflation index by the BLS. Specifically, the housing costs in CPI are covered by owners’ equivalent rent of residences (OER) and rent of primary residence (rent) these are calculated using a panel approach, where rental costs are sampled every six months across six different housing panels. This six-month sampling window creates a lag for CPI housing costs. The latest month’s data only changes housing data by a sixth in the current CPI report, with the remaining prices feeding in from panel data that is up to six months old.

At other times this is a perhaps just a statistical quirk, but it will matter in 2023 as housing costs have broadly been trending down month-on-month since June. Yet, for now, that decline is not being picked up in the CPI index, largely because of the lag in how the CPI measures these costs.

An Alternate Approach?

There is no shortage of improvement suggestions for better incorporating housing costs in CPI inflation. David Wilcox at the Peterson Institute has argued that the way housing costs feed into the CPI could be improved in a 2021 paper. His suggestion is to consider including range of additional measures that provide closer to real time assessment of the housing market from RedFin, Zillow and others. This could improve on a calculation methodology used by the BLS to calculate CPI that is decades old.

Alan Reynolds writing for the Cato Institute has been more vocal arguing that “CPI rent is wrong.” Jason Furman of Harvard has shown that if you swap current house price data in for the CPI’s method of calculation then inflation would have fallen much faster since the summer than the headline CPI inflation implies.

In defense of the BLS, gaining an accurate measure of housing costs is complicated. They use a panel approach to assess costs for a much large and more representative number of properties than they could in a single month. However, technology and reporting have improved, and it may now be possible for the BLS to construct a measure that is both current and relatively accurate.

What This Means For CPI Inflation 2023

This statistical issue cuts both ways. The way that housing costs are calculate means that CPI inflation in 2021 early 2022 may have been understated compared to using a more current measure of housing costs. However, in 2023, it’s likely that CPI inflation will be overstated because of these lagged costs for housing. Basically, housing costs in the CPI are likely to be smoother than other prices, slower to rise in price and slower to fall, especially at turning points in the housing market.

Of course, Jerome Powell has spoken publicly about this, so the Fed is clearly aware of the issue. Still, for the largest component of CPI inflation to be calculated using a method that introduces a lag to the inflation data creates potential confusion.

For now, it appears that 2023 inflation data may be better than expected simply due to declining housing costs eventually feeding into the inflation report.