A graphic with column charts and an upward trending line with an arrow and a house sitting on it

Housing: A Lagging Indicator in CPI’s Marketbasket

You don’t need to be an economist to know that prices for just about everything have soared in the past year. The consumer price index for all urban consumers increased 8.3% in the year ending in August, nearly its highest level in the last 40 years, according to the U.S. Bureau of Labor Statistics. Interestingly, the cost of shelter — by far the largest single component of the CPI — rose at a much tamer annual rate of 6.2%.

This may surprise many people who’ve hunted for a place to live in the past year or two. Indeed, data from multiple sources show that rents and home prices have soared, particularly in the wake of the Covid-19 pandemic, which pushed many consumers to seek new, more, or bigger housing. For example, the average apartment effective U.S. rent rose 14.6% in the year ended June 30, 2022, to a record $2,080 per month, according to CBRE Research, which tracks 63 markets nationwide. The surge was most notable in Florida and other Sunbelt markets: Orlando (up 24.8%), Tampa (24.2%), Miami (22.6%), Nashville (20.4%) and Austin (19.7%).

Moreover, the sales prices of existing homes nationwide jumped by more than double digits each of the past two years, according to the National Association of Realtors and the S&P CoreLogic Case-Shiller Home Price Index. To sum up: Private data sources show big increases in housing costs recently while the government’s official data reveals more moderate increases.

Measuring different things

A basket of groceries sits on a table with a grocery aisle in the background
Spiking prices for food has been a major reason for increasing inflation, but housing is by far the largest share of consumers' living expenses.

Economists say the reason the indices show different results right now is because they measure different things. The private sources look at the market, or marginal, prices new renters are currently paying; the CPI looks at what households are paying on average. (Figure 1) This difference doesn’t amount to much when inflation is relatively steady, but when market rents fluctuate rapidly this change is slow to be captured in the CPI since most renters have annual leases and homeowners have longer tenure. So, a spike in new rents won’t hit most households right away.

“It takes time for the CPI to catch up,” said Hector Sandoval, an economist and director of the Economic Analysis Program at the University of Florida’s Bureau of Economic and Business Research. To understand why this discrepancy exists and its significance, it helps to grasp the mission of the CPI: to measure inflation in consumers’ day-to-day living expenses.

This is a big job: Millions of everyday Americans depend on cost-of-living increases pegged to the index, including Social Security beneficiaries and military retirees. Consider that housing is by far the largest share of consumers’ living expenses, changes in housing expenditures have a big impact on how much people can spend on other goods. Also, importantly, housing is a core expense that the Federal Reserve uses to guide policy on raising and lowering interest rates.

Figure 1 – Source: Bureau of Labor Statistics

Digging deeper

Look under the hood of how the BLS calculates the monthly CPI and you’ll find three primary surveys. First, data collectors visit, call, and check online sites to obtain the prices of 80,000 items in a basket of goods and services that represent what Americans buy — everything from grade A eggs and sports bras to car tires and sports drinks. Secondly, it conducts a housing survey by gathering information from thousands of landlords and tenants to find out how much people pay on average in monthly rent. Finally, the government determines the relative importance of all these expenditures in family budgets by interviewing and collecting spending diaries kept by sample households.

Just one thing is missing: The price of houses, often the largest investment people will make in their lives.

Figure 2 – Source: Bureau of Labor Statistics

It turns out, the BLS doesn’t measure the price of houses listed or sold. Instead, it tracks what it calls “owner’s equivalent rent,” or OER, as if a homeowner rented to themself. Sample homeowners are asked a counterfactual question: “If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?” These responses are solely used to help determine shelter’s relative importance in the CPI; the BLS then imputes the rental equivalence of houses based on rents in the same neighborhood. As of yearend 2021, BLS calculated that “shelter” makes up nearly one-third of the CPI — largely split between OER and rent as a primary residence — with the larger “housing” component accounting for 42% of CPI. (Figure 2)

42.2% Housing Break-down

Housing TypePercent
Owner Equivalent Rent24%
Rent as Primary Residence7%
Other Shelter2%
Other Housing9%
Shelter: 33%

So why doesn’t the BLS directly include the price of houses in the CPI? The answer is found in the unique features of a house. BLS considers buying a house an investment, rather than consumption. It provides shelter to those who live in it, of course, but this is dwarfed by the investment value of the house.

Now that the Fed is increasing interest rates, one of the first markets affected is the housing market … People say ‘I’m not buying.’ That keeps them in the rental market and pushes the rents up.

— Hector Sandoval
University of Florida economist

What’s next?

If there’s good news for the economy right now, it’s that the sharp spikes in the price for food, fuel and many other goods have shown signs of stabilizing. This is largely in response to the recipe the Federal Reserve cooked up earlier this year to increase interest rates to beat back mounting inflation. Of course, this is bad news for those looking to borrow funds, notably house hunters who face steeply higher mortgage rates. That may mean more renters, which would increase demand and raise rents.

“Now that the Fed is increasing interest rates, one of the first markets affected is the housing market,” Sandoval said. “People say ‘I’m not buying.’ That keeps them in the rental market and pushes the rents up.”

Graphic with many up arrows mixed among stacked houses and binary code

So, keep a close eye on the CPI, and particularly the housing component of the index. Even if marginal rents on apartments hold steady, this component of the CPI will likely continue to rise well into 2023. One upward pressure on CPI is the delayed housing component that has yet to fully reflect the past year’s pricing spike. Another pressure will come as leases expire and renters renew or seek new dwellings in this higher interest rate environment.

“I think housing will continue pushing up CPI,” Sandoval said.

The Puzzle of Measuring Housing Costs in CPI

Until 1983, the Bureau of Labor Statistics based its measure of homeowner cost largely on the value of a house. But the BLS recognized this approach had a “long-recognized flaw” — that owner-occupied housing combines both consumption and investment elements, and the consumer price index (CPI) is designed to exclude investments. Also, the old method proved untenable in the high-interest environment of the 1970s and 1980s “as it tended to amplify the volatility in inflation,” according to a report released in May by a committee of the National Academy of Sciences that examined ways to improve the CPI.

The approach used now — called rental equivalence — measures how much owner-occupants would hypothetically pay to rent their own dwellings. This method has its own flaws, according to experts. Among other things, the BLS imputes owner equivalent rent from units in the same Census tracks, but it only samples each housing unit every six months, which is problematic when rents change rapidly. Also, some neighborhoods have few single-family rental units to compare with and they may not have the same attributes as owner-occupied houses. Finally, the CPI captures average rents not the more dynamic market rents that a new renter would pay today.

The National Academy of Sciences’ committee explored the pros and cons of alternative approaches used by some other developed countries. These included tracking the cost of acquiring a house, the opportunity cost of investing in a home and the out-of-pocket expenses of owning a home. But the committee concluded the options pose problems, such as high volatility, adverse reactions with Fed monetary policy and implementation issues.

In the end, the committee recommended BLS stick with its current approach of using rental equivalence. Nevertheless, it proposed several ways the BLS could refine its methods, such as supplementing its traditional surveys with alternative data sources — including property tax records and Census Bureau’s American Community Survey. This would allow for improved coverage of single-family homes and the CPI’s ability to reflect rapid changes in rent growth. BLS officials say they are exploring these and other ways to “modernize” the CPI.