Housing Booms, Inflation Measurement, and Monetary Policy Stephen G. Cecchetti Brandeis International Business School

US Housing Price-Earnings Ratio (Value/Rent) Source: Federal Reserve and BEA

3 The Impact of Housing Booms Housing and Macroeconomic Performance Closer to 100% of GDP and widely held. Wealth effects tend to be large (too large?) Housing Booms  Lower growth Higher inflation

Housing Booms: Output: Lower average, higher variance, worse tail Prices: Higher Average

5 Tails of the Distribution Risk Management is about the Bad events What happens to the 10 th percentile of the output gap? 90 th percentile of the price-level gap?

US GDP Growth Following an Housing Boom (10% quantile)

Inflation Following an Housing Boom (90% quantile)

8 The Questions 1.Should housing costs or price be included in a price index used for monetary policy? 2.Should a central bank target housing prices separately from inflation (and real growth)? 3.Are housing prices relevant indicators for monetary policy?

9 Preview of the Answers 1.Housing might be included in a price index as a part of the cost of living 2.Central banks should not target housing prices. 3.Housing prices are relevant indicators. Housing booms & busts lower growth & raise inflation.

10 Why Measure Housing Prices? 1.GDP: deflate nominal construction 2.GDP: compute real & nominal consumption 3.CPI/HICP: Measure change in cost of living 4.Monetary policy

11 Methods for Including Housing User Cost / Rental Equivalence NIPA Approach Requires imputation Tendency for rents  when home prices  Money Outlays / Payments Cash-flow approach Homeowners are hedged Net Acquisitions Analogous to treatment of consumer durables

12 Owner-Occupied Housing What is the role of land? You live in a house on the land. Isn’t housing an investment? A house is a place to live.

13 Owner-Occupied Housing 1.Deflate Residential Construction: Acquisition Price of New Homes 2.Real & Nominal Consumption: Imputed Service Flow 3.Cost of Living: a.Short-term: Service Flow b.Long-term: Cost of Life, include asset price

14 The Central Bank and Housing Choice depends on why we care about inflation Long-term decision making is difficult Argues for a cost of life

15 Some Examples Substitute Resale Prices for Rent (assumes real interest rate is constant) Cost of Life Index (asset price in net present value of lifetime services)

Putting Home Sale Prices in the Core PCE Price Index : 3/4 percentage points higher!

17 Housing and the Cost of Life Changes in the Cost of Expected Lifetime Consumption (also called an Intertemporal Cost of Living Index) Depends on Prices of consumption now: Traditional Consumer Price Index Prices of consumption later: Asset Prices Housing services are ¼ to ⅓ of consumption

18 Dynamic Factor Index: Intuition Individual product inflation = common inflation + idiosyncratic inflation Objective is to measure common inflation Can also be interpreted as a “pure” price index Result

19 Example: U.S. 9 components of the U.S. CPI plus Housing, Inflation Measure Average Annual Growth Rate CPI2.21 CPI ex food & energy2.28 DFI (no assets)2.34 DFI w/ housing2.49

20 Example: U.S. Conclusion: Long-run trend is different Short-run movements are different Would policy have been different?

21 Examples: 12 Country Comparison Quarterly data 1978 to 1999 DFI including Retail Prices Housing Prices Stock Prices

Source: Bryan, Cecchetti, and O’Sullivan “Asset Prices in the Measurement of Inflation,” De Economist 149, no. 4, 2001,

23 Example: 12 Country Comparison Housing has significant weight in all countries Often bigger than weight on retail prices

24 What Should Policymakers Do? Goal is stabilize prices (and growth) Target what you care about, NOT housing prices! Two possibilities: 1.Change the targeted index to one with housing. 2.Include housing in interest-rate reactions.

25 What Should Policymakers Do? Practical arguments suggest the second Consumer prices are well understood CB would have to produce the index it targets Reaction is flexible

26 Conclusion Housing booms influence CB objectives No choice but to consider them Treatment in a price index affects policy short-run movements in inflation affected long-run trends in inflation changed