House prices and inflation targeting

"Should house prices be included in the CPI?" is not a good question to ask.

The best answer to that question is another question:

"Why do you want to know?" Or, "It depends; what are you planning to use the CPI for?"

Instead, it would be better to ask the question in a different way -- one that already answers that second question. Like:

"Should house prices be included in the price index that the Bank of Canada uses to define 'inflation' when it targets inflation?" (They aren't really included now, except very indirectly over the longer term -- long story (pdf).)

It is easy to sketch a model where house prices should be included in the price index the Bank of Canada targets, or where only house prices should be included in that index.

Suppose that nominal house prices were sticky, but that all other prices (including wages) were perfectly flexible. Then you could make a good case that the Bank of Canada should target the inflation rate of house prices only. The argument follows directly from the idea of "targeting the stickiest price".

Suppose there were a real shock that would require the relative price of houses to rise to restore equilibrium.

If the Bank of Canada targeted house price inflation, the nominal prices of all other goods would fall as a result of that real shock. But since, by assumption, the nominal prices of all other goods are perfectly flexible, they would fall instantly, restoring equilibrium instantly. A fall in the price of all other goods raises the relative price of houses, without the nominal price of houses needing to do anything. Which is good, because the nominal price of houses can't do anything quickly, by assumption.

If instead the Bank of Canada targeted inflation in all the other prices, and ignored house price inflation, the same real shock would cause an excess demand for houses, because the actual relative price of houses would rise only slowly towards the new equilibrium price, and so would be below that equilibrium price in the meantime. There would be a housing shortage.

If we make the exact opposite assumption, that house prices are perfectly flexible and all other prices are sticky, we get the exact opposite policy recommendation. The Bank of Canada should target all other prices, and ignore house price inflation. Because if the Bank of Canada targeted house price inflation (or even just included house prices in the index it targeted), a real shock that required the relative price of houses to rise would cause a recession. Because it would require the prices of all other goods to fall, and they can't fall instantly, by assumption, so those prices would be higher than equilibrium in the short run, which means all other goods would be in excess supply. (The market for houses would always be in equilibrium, regardless of what the Bank of Canada targeted, since house prices are perfectly flexible.)

What about the empirical evidence?

Eyeballing the Teranet-National Bank composite 11, (click on "Historical Charts - National Composite Index Values and Sales Pair Count" on the right side of the page) we see that: house prices rose more quickly than normal from early 2006 to mid 2008; then reversed course and fell quickly to early 2009; then reversed course again and rose more quickly than normal, with a gradually slowing rate of increase.

This gives us a rough idea of how the Bank of Canada's policy would have been different than it actually was, if house prices had been included in the price index it used for inflation targeting. Monetary policy would have been: a little tighter than it actually was from early 2006 to mid 2008 (which would have been good); then looser than it actually was until early 2009 (which would have been very good); then a little tighter than it was until recently (which would have been bad).

Overall, this suggests that monetary policy would have been better than it actually was if the Bank of Canada had been targeting 2% inflation for a price index that included house prices properly. But not unambiguously better, because monetary policy would have been tighter during the slow recovery. And how big those differences would have been would depend on how big a weight house prices had in the price index.

The house price guard dog, in other words, barked correctly two times out of three. The NGDP guard dog did better, barking correctly all three times. And the NGDP dog barked loudly enough for us to hear, if we had been listening. Unless house prices had a big weight in the price index, we might not have heard the house price dog over all the other price dogs.

Comments

[Vladimir]

Is the price of houses - among other things - a proxy for credit conditions? Sometimes people argue that lower interest rates drives house prices higher and vice versa but it seems that the larger and sustained rises in house prices are driven by easy credit. Therefore when anyone says "lets follow house prices" I get the impression that what they really mean is that the central bank has to pay more attention to credit conditions and thus the role of credit in the business cycle.

[Nick Rowe]

Vladimir: you might be right. But a lot of people get confused between: high/low interest rates; tight/easy credit; tight/loose monetary policy. For example, we can imagine a world in which people want to save more, and so interest rates fall, but lenders do not relax their standards, and inflation and NGDP growth stay the same.

[Frank Restly]

"Suppose there were a real shock that would require the relative price of houses to rise to restore equilibrium."

Does the central bank of Canada (or any other central bank) have to tool(s) needed to change the relative price of one good versus another?

If it does, then having a composite CPI is meaningless - the central bank could simply target the price of each good individually. If it does not, then having housing prices in the CPI would be "better" than excluding them.

[Squarely Rooted]

Here's something I've been puzzling over:

Over the past decade, nominal prices for toys in the US have declined by ~43 percentage points, according to the relevant CPI series. This of course means the real price of toys has decline by more than that, ~66pp, once you adjust for the overal ~23pp increase in the price level. In the same way that we understand that an time that cost $100 ten years ago and $123 has had a constant real price, we understand that a toy that cost $100 ten years ago and costs only $57 today has, in real terms, declined even more than a nominal comparison suggests. We similarly understand that many such things - televisions, cellular phones, computers, clothings - can simultaneous decline in nominal hedonically-adjusted price over the course of a decade and that by no means implies there has been no inflation.

So far so good, right? This is, as far as it goes, fairly generally accepted stuff. Here's my puzzle: is it possible for EVERY good and service to decline in nominal price but to still have inflation? If we can acknowledge that changes in supply & demand, productivity, average quality, etc can causes prices of certain items or kinds of items to decline nominally even as inflation increases, couldn't everything? If we suddenly developed and rapidly integrated into our economy boundless renewable energy, perfect 3d printing, and highly advanced robots to perform most services, we'd likely see the price of almost everything plummet - but would that tell us anything about inflation?

I guess what I'm wondering is - to what extent is inflation a ceteris paribus statement about the value of money as determined by monetary policy, and to what extent is inflation simply a measure of the lived experience of the price level?

This may be a dumb or incoherent comment. If so, I blame Friday and the World Cup.

[Nick Rowe]

Frank: you have either ignored, or totally misunderstood, my argument in this post. And I lack the patience to repeat it.

[Nick Rowe]

Squarely: the standard definition of "inflation" is the average growth rate of prices over time. So if every price fell, then there was deflation by definition.

But an old definition of inflation, and one that some Austrians sometimes still use, is an increase in the supply of paper money. If we accept that old definition, then it would be possible to have "inflation" and yet all prices fall, because of rising productivity. But if we had "inflation", and an even bigger increase in the demand for money, and no change in productivity, we could also get falling prices.

The one advantage of something like the old definition is that it does let us talk coherently about the consequences of "inflation". Under the standard definition, the question doesn't make sense, because it depends on what causes inflation. We have to talk instead about the consequences, for example, of the Bank of Canada deciding to increase its inflation target. And we end up talking about "good deflation" (caused by rising productivity) and "bad deflation" (caused by monetary policy).

[Frank Restly]

Nick,

Your first question was: "Should house prices be included in the price index that the Bank of Canada uses to define 'inflation' when it targets inflation?"

Your argument was:

"Overall, this suggests that monetary policy would have been better than it actually was if the Bank of Canada had been targeting 2% inflation for a price index that included house prices properly."

I agreed with your conclusion or did I miss something.

What drew my attention was this:

"Suppose there were a real shock that would require the relative price of houses to rise to restore equilibrium."

Here you offer possible central bank options depending on which prices are sticky. Here the central bank isn't targeting inflation or a nominal GDP target, but some notion of equilibrium in relative prices. How does a central bank targeting a price index (or nominal GDP) establish equilibrium and why would it necessarily want to?

That real shock could be technological progress - horse drawn wagon is replaced with motorized vehicle. Should the central bank act to support the relative price of horse drawn wagons relative to motorized vehicles?

[Nick Rowe]

Frank: re-read my post. We don't want bad monetary policy to cause a housing shortage. We don't want bad monetary policy to cause a recession.

Now stop commenting.

[Josh]

Nick,

See my response here: [Link here, and my response in comments, NR]

[Squarely Rooted]

Nick,

You clearly got my question, and I hadn't realized that the Austrians draw that distinction (though it makes perfect sense in their context). It was something I'd thought about both when thinking about the brief inflation spike of 2008, the inflation of the 1970s, and the Great Deflation of the late 19th century. It does seem to me that talking about inflation in the context of "zoning restrictions causing widespread shortages of housing in high-wage coastal cities" is very different from talking about inflation in the context of "the central bank increasing its purchasing of government debt." Clearly constructs like "core CPI" are trying to address this somewhat, but I think people in their minds flip back and forth between both the standard and old definitions of inflation and this leads to more confusion rather than less. Especially when people start talking about "[X] inflation" - food inflation, energy inflation, house price inflation, etc.

[Jacques René Giguère]

Especially if people mean "inflation is bad ...unless it rises the price of my house!"

[Nick Rowe]

The following is from Andrew Baldwin, via email (for some reason he had difficulty commenting). Andy is the Canadian expert on methods of including house prices in the CPI.

"Nick, you are quite wrong in saying that “[house prices] aren't really included [in the CPI] now, except very indirectly over the longer term”. I don’t know why you would say that since you actually reference a paper I co-authored which in no way supports that view. The existing CPI methodology for owner-occupied housing (OOH) is better described in my paper for the 2011 annual CEA meeting, “A Better Inflation Indicator”:
http://economics.ca/2011/papers/BA0017-1.pdf
I call it the lessor’s deductible cost approach, since the idea was to monitor deductible or potentially deductible costs of an owner-occupied dwelling if a lessor were renting it out. This is why depreciation expense is included, although it is an imputed cost rather than an actual expense. It is why mortgage interest is included, but mortgage payments are not, and why the opportunity cost of owner’s equity is excluded. The treatment OOH in the United Kingdom Retail Price Index (RPI) is very similar, and they use the term “accounting” approach to describe it, which also gives an idea of the logic behind it.
In addition to mortgage interest and housing depreciation, house prices are reflected in the CPI in the components for real estate commissions and land transfer taxes, both part of the basic grouping other owned accommodation. The new housing price index is used as the proxy for real estate commissions rather than the Teranet National Bank house price index as one would think. Land transfer taxes is also proxied in a way too silly to detail, but the NHPI has a minor role in the proxy for this series too.
The UK RPI does not treat stamp duty as being in scope, unlike the Canadian CPI. It is hard to see why since it does include estate agents’ fees and other costs related to real estate transactions. However, the quarterly index for OOH based on the net acquisitions approach that the Office of National Statistics will publish starting in September will have a component for stamp duty. It will not be proxied but will be properly measured, using a price index for resale homes and the appropriate rates for stamp duty.
The Bank of Canada’s core CPI excludes the mortgage interest component along with seven other volatile CPI components. The OOH series for the core CPI can be viewed as an approximation to the OOH component based on the net acquisitions approach to be calculated by the UK and every other country in the European Economic Area. Although Mark Carney is oblivious to the fact, the superior performance of Canada in the global financial crisis undoubtedly stems in part from the fact that it was the only G-7 country whose central bank targeted an inflation indicator that was impacted by current house prices.
If you watch virtually any press conference by Governor Carney since he took over at Threadneedle Street, there is usually at least one reminder to a journalist that the Bank of England does not target housing prices, delivered in a tone that suggests it would be wicked to do so. So far not a single British journalist seems to be concerned that Governor Carney spent nine years at the Bank of Canada and the Department of Finance defending a target inflation indicator that does include housing prices.
As for what is the most appropriate treatment of OOH in an inflation indicator to be used by a central bank, there is really no alternative to the net acquisitions approach is there? You were kind enough to come to my seminar on Twenty Years of Inflation Targeting at the Bank of England last September. If you haven’t found the time to read the paper that accompanied it you should do so. Thirty countries aren't all going to be calculating new OOH series in a couple of months without a good reason. Here’s a link to my paper:
http://web5.uottawa.ca/ssms/vfs/.horde/eventmgr/001220_001379532586_baldwin.pdf

The above was by Andrew Baldwin