By Steven K. Beckner

(MNI) – The acceleration of the “owners equivalent rent” component
of the Consumer Price Index — a proxy for housing costs — could put
“substantial” upward pressure on the core CPI and send a “false signal”
on inflation, a top economist at the Cleveland Federal Reserve Bank
warns in a research paper released Thursday.

Brent Meyer, a Cleveland Fed senior economic analyst, suggests that
the OER is being distorted by problems in the housing market that are
inducing many people to move into rental units, and that in turn runs
the risk of skewing the inflation indicators which Fed policymakers use
to make monetary policy.

The OER, which makes up 25% of the CPI and nearly a third of the
core CPI, attempts to measure the cost of consuming owner-occupied
housing by comparing it to what it would cost to rent the same housing.
The Bureau of Labor Statistics defines the OER as “the change in the
amount a homeowner would pay to rent” his or her home in a competitive
market, and it is calculated by surveying nearby rental units.

Meyer notes that the OER “has begun to accelerate, rising at an
annualized rate of 2.3% over the past six months.”

“Given a backdrop of generally subdued underlying inflation
elsewhere in the index, a persistent increase in the relative price of
OER-the largest component of the consumer market basket by far-may
create upward pressure on measured inflation,” he writes.

“A problem can arise in these measures when a component that is
less likely to exhibit extreme price changes has an unusually high
weight,” he continues, noting that the OER is roughly four times as
large as the next largest component, and it is usually not volatile
enough to end up in the tails of the price-change distribution. As a
result, OER is often the median component.”

“Because of these factors, a relative price shock to OER could lead
to a false signal of inflationary pressure in these price statistics,”
Meyer adds.

The economist points to a marked divergence between house prices
and the OER. While house prices have fallen 30% over the past five years
“and are still trending down,” the OER has increased 8% over the past
five years “and has started to accelerate in recent months.”

Meyer warns that “conditions in the housing market are likely to
lead to a continued acceleration in OER over the next few years.”

In the face of high unemployment, tight mortgage credit,
foreclosures and other forces, there has been “a dramatic influx of new
renters,” he notes, and “all this new demand is starting to put pressure
on rental vacancy rates, driving them down sharply in recent quarters.”

“The increasing scarcity of rental units is in turn putting upward
pressure on rents,’ he adds.

Meyer suggests that the BLS is overstating the cost of housing in
the way it calculates the OER.

“Because the BLS uses rents to calculate OER, frictions that affect
a person’s ability to purchase a home — such as credit market frictions
— don’t offset increases in rent, even though they show up as an
artificial increase in rental demand,” he writes. “Also, using rents to
calculate OER doesn’t account for a glut of vacant homes, which would
(all else held constant) lead to a decrease in house prices and thus the
cost of carrying a mortgage.”

“This disruption in the housing market may lead to questions about
OER, specifically whether it appropriately picks up changes in the
shelter cost for owner-occupied housing,” he continues.

“Certainly, an increase in OER given the oversupply of vacant homes
and credit frictions that are preventing renters from becoming
homeowners could be used as evidence,” he goes on. “And, given that OER
is measured by nearby rents, transitioning would-be renters back into
homeownership may alleviate some of the upward price pressure. Yet it
isn’t clear whether those vacancies are habitable or whether those
would-be renters ought to (or want to) purchase a home.”

“Regardless, the potential remains for a change in the relative
price of owner-occupied shelter costs to give a false signal of
inflationary pressure, given the behavior of the rental market,” Meyer
asserts.

He projects the OER will rise 3.5% by the fourth quarter of 2014,
much faster than other CPI components and warns that will lead to a
distorted picture of inflation.

“Given the relatively subdued rate of inflation seen elsewhere in
the consumer market basket, an acceleration in OER of this magnitude
could put a substantial amount of pressure on core CPI inflation.”

** Market News International **

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