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Owner-occupiers and the price index

The way in which owner-occupied dwellings should be dealt with in a Consumer Price Index has been, and remains, a subject of heated controversy in many countries. The purpose of this entry is to explain why.

The economists’ approach.

Leaving aside the quality of public services, the environment, crime and so forth, and regarding the standard of living as a function of the level and composition of individuals’ consumption, this standard depends upon the amount and range of goods and services they consume. These include the service provided by rented accomodation, which can readily be priced, and the similar services yielded by a flat or house owned by the consumer who occupies it. Its cost to a consumer is, according to the economic way of thinking, an “opportunity cost”, namely what he or she sacrifices by living in it. This cost, according to many economists, is what should form a component of a Consumer Price Index. Opportunity cost can be looked at in two ways, since there are two alternatives to continuing to live in an owner-occupied dwelling. One — supposing that it is one year’s cost that is to be considered — is to sell it, earn interest on the owner’s capital thus released, and buy it back a year later, making an allowance for its physical depreciation. This can be called the “alternative cost” approach. The other, the “rental equivalent” approach, is to let it to someone else for the year, in which case the cost is the rent that could be obtained for it. Most people do not think about their dwelling in either of these ways, but this does not bother the theoretical economist for whom consistent logic is what matters. There are, of course, practical problems in implementing either of these economists’ approaches. Thus, with the alternative cost approach, if house prices are rising fast the cost can be negative and then become sharply positive once house prices start to fall, so such an index would be very volatile. On the other hand, with the rental equivalent approach, there may be difficulty in estimating the movement of rental values of types of property which are not actually rented. If one or other of these measures of the consumption of the services of owner-occupied dwellings is included in consumption, then it must be included in income too, for income equals consumption plus saving. This means that if the movement of incomes is to be compared with the movement of the Consumer Price Index, incomes must be expressed as money income plus this imaginary consumption value. That is logical, but it may not be what users of the index want. Although the argument has been expressed in connection with owner-occupied dwellings, the logic applies equally to all durable consumer goods and services. Furniture, carpets and domestic appliances are not used up soon after purchase in the way that food is. Like dwellings, they yield a consumption service that can continue for years. Furthermore, since strict logic is to be adhered to, there are durable services as well that ought to be treated in the same way; the service consumers derive from appendectomies or crowned teeth continue for a long time. Since estimating values for these components of consumption has not been tackled, the economic theorists are torn between their desire for intellectual consistency and their recognition that inclusion of the opportunity cost of the use of durables is impracticable.

Spending

Another approach is to concentrate on spending. Everyone agrees that repairs and maintenance expenditure of owner-occupied dwellings should be covered in a Consumer Price Index, but the spending approach would include mortgage interest too. This turns out to be quite complicated, conceptually as well as in practice. To explain what is involved, consider a Consumer Price Index computed with reference to 2009 for just one sole consumer who bought her house in 2006, financing half of this sum by raising a mortgage. The problem is to compare how much interest such a consumer would now be paying with the interest that was paid in 2009. Since the aim is to compare like with like, that requires an estimate of how much interest would be paid now in the year 2010 on a similar house bought and 50% mortgage-financed three years ago, in 2007. It does not require an estimate of how much that identical person is paying now on the actual house she bought in 2006, even though that is what personally concerns her now. A Consumer Price Index compares how much it would cost now to do exactly what consumers did in the reference-period with what it cost then. Application of the principle thus requires that the index for our one houseowner should reflect the movement of the prices of houses like hers from 2006 to2007 and the change in interest rates. If she took out a fixed-interest rate mortgage it is the change in interest rates from 2006 to 2007 that counts; if she took out a variable interest mortgage it is the change from 2009 to 2010 that counts. Thus her current index with 1999 as reference-period will stand at more than 100 if house prices or, in the case of a fixed-interest mortgage, interest rates rose between 2006 and 2007. The application of this principle in the owner-occupied dwellings component of a Consumer Price Index is known as the “debt profile” method. It means that the current movement of the index will reflect past changes in dwelling prices and interest rates. Some people regard this as odd. Quite a few countries use the debt profile method, but in doing so most of them behave inconsistently. Consistency would require that the index should also cover the interest on consumer credit instead of the whole price paid for the products bought on credit if it covers mortgage interest payments. Products bought on credit would then be treated in the same way as owner-occupied dwellings. Variants of the debt profile method are employed or have been proposed. One example is to include downpayments as well as interest. Another is to correct nominal mortgage rates for changes in dwelling prices or for changes in the rest of the Consumer Price Index to obtain a “real” rate of interest. Also, other methods may be used alongside the debt profile method. Thus several countries include a purely notional cost of depreciation as an additional index component, applying an arbitrarily estimated, or rather guessed, depreciation rate to the value of the stock of owner-occupied dwellings. Finally, one country includes both mortgage interest and purchase prices in its index.

Transaction prices

The third approach simply treats the acquisition of owner-occupied dwellings in the same way as acquisitions of other durable products are treated. This means:

• Taking account of the transaction prices agreed;
• Ignoring whether payments are delayed or are partly financed by borrowing;
• Leaving out second-hand transactions. Second-hand purchases correspond to sales by other consumers. Thus only new dwellings would be included.

Furthermore, expenditure on enlarging or reconstructing an owner-occupied dwelling would be covered, in addition to regular maintenance and repair. Two arguments of an almost theological character are advanced in connection with this transactions approach. One is that purchases of new dwellings are treated as Investment in the System of National Accounts, so should not enter a consumption price index. It is said that this is more than just a matter of terminological uniformity. For example it may be thought to help understanding and facilitate economic analysis if what is included under the heading of Consumption is the same in the Consumer Price Index and in the national income and expenditure accounts. Since these accounts include the equivalent rental value of owner-occupied dwellings, the equivalent rental approach would have to be applied in the Consumer Price Index too. But the national accounts do not apply it to other durables, so the argument demands consistency in one respect but accepts its rejection in another. The other argument is that the prices of new dwellings should exclude that part reflecting the value of the land, since this is an irreproducible and permanent asset that cannot be said to be consumed. This would presumably mean deducting site value from the price of a dwelling, site value presumably being defined as the price the site would fetch at auction if the dwelling were not on it. How this is to be understood in the case of multiple dwellings remains unclear.

Confusion

It is apparent that much of the muddle in discussing the merits of the different approaches arises from the promiscuous mixing up of arguments about feasibility, about dislike or approval of the way the index would move under a particular approach and about principles of various, often incompatible, sorts. Feasibility is naturally important. The difficulty of dealing with site values is obvious. The statisticians in a country lacking a good dwelling price index (which is required for all except the rental equivalent method) will only go along with a proposal to use such an index if they can obtain the necessary additional resources that will enable them to compile one. Even obtaining mortgage interest rate data can be a major task in a country with a multitude of mortgage lenders and many types of mortgage. Dislike of the effect upon the behaviour of the Consumer Price Index arising from the adoption of some methods can be a powerful, if sometimes unprincipled, argument. Dwelling prices are volatile, and so, therefore, would be an index incorporating the current value of a dwelling price sub-index which, in some countries would have a large weight under the third approach. Furthermore, the weight for owner-occupied dwellings could be altered considerably when reweighting was undertaken. (It could even become negative under the alternative cost approach if weights were estimated for a year during which house prices had been rising steeply). Then there is the point that a rise in interest rates designed to halt inflation could paradoxically make inflation appear higher if current interest rates showed up in the index. The economists’ principles are not acceptable to all; nor is insistence upon consistency between the treatment of owner-occupied dwellings and other durables.

Clarity

Much would be gained if two sets of problems were distinguished.

• What is the Consumer Price Index to measure?
• How can that be achieved?

Another way of putting this is to distinguish:

• What is the question that should be answered? This is a matter for policy makers and other users of the Consumer Price Index.
• How can it best be answered? This is a matter for the statisticians.#

The three approaches should not be regarded as rivals, they are different answers to different questions. One, or possibly more, should be chosen. The three questions can be formulated as follows:

1. Opportunity cost. What is the change through time in what would be the opportunity cost of the reference-period consumption of the services of owner-occupied dwellings?
2. Spending. What is the change through time in the cash outlays that would correspond to the reference-period cash outlays in respect of owner-occupied dwellings?
3. Transactions. What is the change through time in what would be the purchase value of the reference-period net acquisition of owner-occupied dwellings by consumers?

Which question is to be answered is, as just stated, a policy matter, depending upon the purposes the index is to serve. It is not an issue for statisticians to decide. Their job is the technical, professional one of compiling one or more indexes that answer the selected question or questions as well as possible, given the resources at their disposal. In a perfect world this is how the owner-occupied dwellings issue would be resolved. But the world is not perfect.