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Inflation measures used to guide Fed policy should include housing prices. At The Financial Times, Alliance Bernstein Chief Economist Joseph Carson explains:
The American economy has experienced many booms and busts in its history but, in the past two decades, the problems have been particularly acute in the asset markets. Both the 1990s dotcom equity bubble and the 2000s housing bubble saw large, persistent increases in asset prices. And each time, the economic tipping point came from sharp falls in asset prices and the abrupt changes in balance sheets on spending and investment decisions.
This means the Federal Reserve must elevate the goal of maintaining financial stability to a more equal position alongside full employment and stable prices. Policymakers may need to raise interest rates to damp asset price cycles, rather than reserving the tool for fighting general inflation. Yet, to do that, the Fed needs a good way to monitor and address asset price cycles within their existing price-targeting regime.
The answer is simple: government statisticians should create a broad transaction-based price index, which would include house prices and serve as a complementary indicator to gauge economy-wide inflation. It’s not a novel idea. The original consumer price index included house prices. But they were removed in 1983 and replaced with “non-market rents” — an estimate of how much owners could charge to let their homes. Then in 1998, all links to the actual real estate market were severed when we stopped sampling homeowners about rents.
Including house prices in the new index would not guarantee a higher rate of inflation as high house price inflation might be offset by smaller increases, if not a decline, in rents or offset by price changes in other components. But large and persistent acceleration in this new economy-wide index would be a sign of more general inflation.
The traditional consumer price index is a hybrid price series that includes both market prices and non-market prices. Within it, the non-market rent component creates two problems: first it is nearly one-quarter of the overall index and therefore it can create the illusion of general price stability, and second, the rent estimate misses important price signals from the real estate market (which have become increasingly correlated with equity prices).
Accurate measurement of inflation is critical for any central bank whose mandate is to maintain financial stability. If published price indexes miss important price developments, it could lead to costly real or financial price imbalances. In fact, the past two recessions occurred after destabilising price increases in the asset markets and relative stability in the published inflation indexes.
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