Over the past year or two even the mainstream media seems to have had flickers of realisation about the problems with official inflation measures. Perhaps their journalists wondered how things could be so expensive with recorded inflation so low? I recall even Bloomberg publishing pieces on exactly that looking at problems in the housing situation in Germany which expressed exactly that with those experiencing reality questioning the official numbers and in more than a few cases suggesting they came from a place far,far away.
Yesterday a member of the Executive Board of the ECB expressed his worries about this area, So let us look at what Yves Mersch had to say.
A prolonged loss of trust in the ECB risks undermining the broad public support that is necessary for central bank independence.
I think he is going a bit far with “broad public support” as most people will only have a vague idea about what the ECB does but let us indulge Yves for now. He goes onto ground which is about as near as central bankers get to admitting the amount of mission-creep that has gone on.
This is of particular concern when the range of non-conventional measures brings monetary policy closer to the realm of fiscal policy and the institutional effects of these policies are becoming more pronounced.
House Prices
This follows a section where he points out this.
The risks arising from strong housing price inflation extend beyond financial stability.
Indeed although the Euro area had lots of problems for financial stability as pre credit crunch house prices in Ireland, Spain and the Baltic States boomed and later bust, which also undermined many banks. However in spite of this he confesses that one way of guarding against this happening again has been ignored.
At present, owner-occupied housing costs are not included in the Harmonised Index of Consumer Prices (HICP) that is used to formulate our inflation aim of below, but close to, 2% over the medium term.
I mean why would you put in something which for many is their largest monthly expenditure? The next sentence covers a lot of ground but the latter part is very revealing.
There are a number of technical explanations for this exclusion, but it is clear that households view the cost of housing as an important part of their lifetime expenditure.
“View”?! The truth is that if we switch to describing it as shelter it is a basic human need. Of course central bankers have a track record in downplaying basic human needs in the way that food and energy are left out of so-called core inflation measures, but this takes things a step further as many of the costs of shelter are completely ignored rather than downplayed. As to the “technical explanations” let us just mark them for now as I will cover them later.
Next we get another example of the central banking obsession with rents.
Rents represent around 6.5% of the basket used for measuring inflation.
Let me explain why. This is because in their Ivory Tower world people consume housing services whatever they do. This works for those who do rent as their (usually) monthly payment fits with that theory. Actually in practice there are more than a few problems with measuring this accurately as I noted earlier in the reference to Bloomberg Germany in particular. Also there are a lot of complaints concerning Ireland too. So even where it should work there are troubles,
But when you apply consumption of housing services to people who buy their own home be it outright or via a mortgage there is trouble. If someone is fortunate enough to buy outright then you have one large payment rather than a stream of services. Even the highest Ivory Tower should be able to spot that this simply does not work. You might think that using mortgages would work much more neatly after all a monthly payment does have some sort of fit with consuming housing services. But for a central bank there is a problem as it is the main player in what the monthly mortgage costs is these days. In the case of the ECB its negative deposit rate of -0.5% and its QE bond buying operations ( currently 20 billion Euros per month) have reduced mortgage rates substantially.
So there is the “rub”. Not only are they reducing the recorded level of inflation with their own policy which is of course trying to raise inflation! But even worse they are raising house prices to do so and thus inflation is in fact higher. It is not the misrepresentation or if you prefer lying that bother them as after all they are practised at that but even they think they may struggle to get away with it. In a way the speech from Yves reflects this because the background to all this is below.
House prices rose by 4.1 % in both the euro area and the EU in the third quarter of 2019 compared with the same quarter of the previous year.
You see why they might want to keep house prices out of the inflation index when we note that the official HICP measure recorded 1% (twice) and 0.8% in that same quarter.
Yves continues the official swerve with this.
Indeed, the United States, Japan, Sweden and Norway already integrate owner-occupied housing into their reference inflation indices.
You see both Japan and the United States use rents as a proxy for owner-occupied housing costs in spite of the fact that no rents are paid. You might think when Yves has noted the influence of house prices he would point that out. After all using fantasy rents to measure actual rises in house prices will only make this worse.
The gap between perceptions and official measures of inflation can complicate the communication of policy decisions. If households believe that inflation is rampant then they will see little justification for unconventional measures, in particular negative interest rates.
There is no little arrogance here in “believe that inflation is rampant” to describe people who have real world experience of higher prices and hence inflation as opposed to sticking your head in the sand for two decades about an important area.
Comment
Even Yves is forced to admit that the omission of owner-occupied housing costs has made a material difference to recorded inflation.
If it were to be included in the HICP, it could raise measured inflation rates in the euro area by around 0.2 to 0.5 percentage points in some periods. Taking that into consideration, core inflation would lift from its current 1.3% to its long-run trend, or even higher, thereby having a bearing on the monetary policy stance.
You can bet that the numbers have been absolutely tortured to keep the estimate that low. But this also hides other issues of which Eurostat provides a clear example below.
the annual growth rate of the EU HPI reached a maximum of 9.8 % in the first quarter of 2007
Pre credit crunch Euro area house prices did post a warning signal but were ignored. After all what could go wrong? But more recently let me remind you that the ECB put the hammer down on monetary policy in 2015.
Then there was a rapid rise in early 2015, since when house prices have increased at a much faster pace than rents.
Or to put it another way the Euro area HICP is full of imagination.
Could it be that it’s just an illusion?
Putting me back in all this confusion?
Could it be that it’s just an illusion now?
Could it be that it’s just an illusion?
Putting me back in all this confusion?
Could it be that it’s just an illusion now?
I promised earlier to deal with the technical issues and could write pages and pages of excuses, but instead let me keep it simple. The consumer in general spends a lot on housing so they switch to consumption where purchase of assets is not included and like a magic trick it disappears. Hey Presto! Meanwhile back in the real world ordinary people have to pay it.
Notayesmanseconomics's Blog 
Talking of official figures being manipulated lower, my union rep thinks that February’s RPI is going to come in at 3.1%, I have told him that figure is impossible as it is totally manipulated lower every year as several large employers use it as a basis for negotiations, but he is having none of it, I fully expect it to have a 2 in front of it. I asked him why they don’t use an independent inflation indicator that reflects the cost of food production and distribution and also energy costs and he seemed quite interested….until I told him it was the price of a BigMac, cue the expected disbelief and ridicule, then I tried explaining purchasing power parity and the Big Mac index compiled by the Economist magazine but I knew it was all over, oh well, looks like another 2% pay rise this year again(achieved only after 6-9 months of pointless haggling and threats) and a likely 5% cut in real wages after REAL inflation is taken into account.
Kevin
Its suits the inflation numbers to come out lower to make Joe Public feel happier. However despite the manipulation the real test as to how people are feeling is looking at other data, and this morning the CBI came out with its retail sales picture being flat with no pick up late January and February.
https://uk.reuters.com/article/uk-britain-economy-retail/uk-retail-sales-steady-in-january-mixed-signal-ahead-of-boe-meeting-cbi-idUKKBN1ZR15X?feedType=RSS&feedName=businessNews
Although many analysts are seeing a Borris bounce in house sales and business optimism Joe Public is keeping his money in his purse or wallet.
Further data on retail sales from this link:
https://www.cbi.org.uk/media-centre/articles/retail-sales-continue-to-fall-flat-in-january/
Retail sales flat and no growth expected for February suggests to me the BOE needs to cut now. At least one member was minded to maintain his stance for a cut unless he saw more far more positive data in January.
What we have seen is declining retail sales, better wage figures but slowing rate of wage inflation and better house prices, together with other business confidence higher, and service figures also higher.
However retail sales are a good indicator as to Joe Public confidence and the data today suggests it weak.
Bear in mind also the banks now charging an overdraft rate of circa 40% now new rules to come in.
Taking account of these factors I am pencilling in a cut of 0.25%.
Hi Shaun
Great article as always. I recently mentioned that my bus fare had gone up 10% recently. And this week they reduced the number of buses per hour. So we end up paying more for a reduced service. I think I’m going to start using a new phrase
#Crap Britain
Thanks
Hi Anteos and thank you
You touch on the issue of quality here ( fewer buses per hour). Inflation indices are supposed to allow for this. However when I investigated in late 2016 ( you may recall the issue of women’s overcoats in the UK ) the claims rather faded and foundered. I am not saying there is no quality adjustment at all but I am saying it is not as good as claimed.
Great blog as usual, Shaun.
One shouldn’t be too hard on potential allies, but it is distressing that after expressing concern about housing price inflation in the EU, M. Mersch would look to the US, Japan, Norway and Sweden as models for how the EU could redesign its target inflation indicator. Norway has imputed rents in its inflation indicator too, by the way, like the US and Japan. The Swedish Rijksbank uses CPIF as its inflation indicator now, which does include housing prices but adopts a user cost approach to measuring OOH. It’s the best of the four as far as sensitivity to housing prices is concerned, but it’s not that great. I rather would have hoped if he were going to cite existing central bank practice he would have mentioned the Reserve Bank of Australia or the Reserve Bank of New Zealand, which both adopt a net acquisitions approach to OOH.
For that matter, the operational guide (preferred core inflation measure) of the Bank of Canada until 2017, CPIX, could be seen as a crude approximation to a net acquisitions approach, since it included dwelling prices but excluded mortgage interest. On that subject, it seems I unfairly maligned my own Member of Parliament, Catherine McKenna, Environment Minister in the last Canadian Parliament, Infrastructure Minister in the current Parliament. After promising to discuss taking mortgage interest out of the Bank of Canada operational guide with the 2021 renewal agreement with me at an all candidates’ meeting, I thought she had brushed me off, but I did have an exchange of e-mails with one of her staffers in Ms. McKenna’s Ottawa Centre office. I never got the full-throated endorsement of my views I was hoping for, but Ms. McKenna sent me a letter on January 10 saying that she had passed on my files to Finance Minister Bill Morneau and I could expect a reply from him, which I have not yet received. So she didn’t renege on her commitment to me at the all candidates’ meeting. She kept her word. As to Bill Morneau’s reaction, je garde espoir. (The French version strikes me as so much more emotive than its English equivalent: “I remain hopeful.”)
The proper measurement of inflation really doesn’t get a proper airing in the Canadian media. We don’t have our own Shaun Richards in Canada, or anyone remotely like you. We could sure use one.
Hi Andrew and thank you
I am pleased that your Canadian MP kept her word. I am sure politicians in Canada are cut from the same cloth as ones over here so it may not be that common.
Meanwhile you may enjoy this exchange with the former Vice-President of the ECB Vitor Constancio.
Yep one of those responsible for ECB monetary policy was unaware that Imputed Rents are in the US CPI. Just the 24%! Yet he apparently feels equipped to criticise suggestions that house prices are a better alternative for the Euro area HICP going forwards.
You may note that once proven wrong he switches to claiming the issue is “small”
Thank you for your reply, Shaun. The US CPI-U annual inflation rate was 2.3% for December 2019, while the rate for imputed rents was 3.3% so one really wonders why Constâncio would think the difference is small. It would seem like a pretty big deal to me, too.
Shaun, great article. I asked Mark Carney on the bus this morning what he thought about the issue of not having house prices in the inflation measure – he was surprised that not everyone’s employer gave them £250k a year on top of their salary to live in central london so hadn’t thought there was any need to measure it. He said he’d mention it to the new guy but couldn’t promise anything.
Good to see Carney is more concerned about the environment by catching the bus rather than mere technicalities on the HPI measure. There are always priorities in life and if everyone did the same there would be less pollution.
I don’t suppose he gave you any hint as to whether he will vote for a cut on Thursday?
What you could have said to him was you were pondering as to whether to ago for a variable mortgage or a fix and wondered what he would plump for in the current economic environment.
‘I mean why would you put in something which for many is their largest monthly expenditure? ‘
Such an obvious question, so rarely asked away from less frequented corners of the web.
It really begs the question of whether the CBers really have any idea what they’re doing or whether they’re just blagging it until they can retire to their RPI linked investments that they’ve told us we don’t need.
Keep it up Shaun.
“It really begs the question of whether the CBers really have any idea what they’re doing or whether they’re just blagging it until they can retire to their RPI linked investments that they’ve told us we don’t need.”
Is that one of those trick questions, because it seems too easy.
Hi Shaun
I think that this lady sums things up admirably.
Sorry, dodgy fingers!
Hello Shaun,
when they put up taxes by RPI and other peoples bennies by CPI , then their remuneration is RPI linked , you know they are committing a fraud.
But its OK , they’re the Government…….
Forbn
Hi Forbin
Oh yes, it is never a crime when the establishment are committing it. On that subject you may enjoy this and understand how Andrew Bailey of the FCA managed to be the new Governor in waiting.
Great stuff Shaun,
In days of old (the 1970’s) the financial media occasionally used Goodhart’s Law to handbag Margaret Thatcher .
No doubt you’ll remember the details but I think Goodhart said ‘A Measure ceases to be a good measure when it becomes a target’ ; or words to that effect.
Hi Eric
Sadly he was not one of my lecturers at the LSE but a couple of his books were text books. One which covered “underfunding” ( a type of anti-QE ) by the Thatcher government was especially useful when we got so much of its doppelganger.
In that vein let us give it a full explanation via Oxford Reference and although they do not say it, the measure referred to was £M3.
“Originally, an economic theory stating that if a particular definition of the money supply were to be used as the basis for monetary policy, the stability of its statistical relationship with spending on the economy would break down and the policy would prove ineffective. The law is now cited more widely to highlight the problems of focusing on the value of any specific variable as an indicator. In simple terms, when a measure becomes a target, it ceases to be a good measure. The applications to performance measurement in management accounting and other aspects of business are obvious.”
So there is the “rub”. Not only are they reducing the recorded level of inflation with their own policy which is of course trying to raise inflation! But even worse they are raising house prices to do so and thus inflation is in fact higher. It is not the misrepresentation or if you prefer lying that bother them as after all they are practised at that but even they think they may struggle to get away with it. In a way the speech from Yves reflects this because the background to all this is below.