Inside the Rent Inflation Measure That Economics Nerds Love to Hate

Inside the Rent Inflation Measure That Economics Nerds Love to Hate

There’s a three-letter abbreviation that economists have begun to pronounce with the energy of a four-letter word: “OER.”

It stands for Owner’s Equivalent Rent and has been used to measure American housing inflation since the 1980s. As the name suggests, it uses a combination of surveys and market data to estimate how much it would cost homeowners to rent the home they live in.

But three years after America’s price surge, it has become almost a cliché for economists to fret about housing. Critics say it is moving so slowly that it does not reflect current economic conditions. Critics argue that it uses complicated statistical methods that make little sense. The biggest haters insist that it gives the wrong impression about the state of inflation.

“It just doesn’t add anything to our understanding of inflation,” said Mark Zandi, chief economist at Moody’s Analytics and a frequent adviser to the Biden administration. Full disclosure: The New York Times called Mr. Zandi for this article because he was one of the many economists complaining about OER on social media. He said he was “not a fan.”

What did this one nerdy inflation component do to attract so much hate?

It more or less prevents an economic happy ending. Property inflation measures were surprisingly stubborn last year and are now a major obstacle preventing overall price increases from returning to normal. That has knock-on effects: Because of persistent inflation, the Federal Reserve is keeping interest rates at more than two-decade highs to try to control prices by slowing the economy.

While there’s no denying that OER has become a major player in America’s inflation fairytale, not everyone thinks it’s the villain. Some economists believe it is a valid and reasonable way to measure an important part of the consumer experience. Ahead of a new consumer price index report due out Wednesday morning, there are some key facts about how housing inflation is calculated, what it means and what it might do next.

Let’s start with the basics. In America, there are two main indicators of inflation: the consumer price index and the personal consumption expenditure index. Both are important: The CPI is published earlier each month and provides an initial overview of price developments over the last month. PCE comes later, but it is the index that Fed officials are targeting with their 2 percent inflation target.

The two indices follow slightly different concepts. The consumer price index attempts to capture what people buy out of pocket (i.e., what you spend), while the personal consumption expenditures measure captures the costs of things like medical care that are funded through employer-provided insurance (i.e., what you consume).

Both rely on the same underlying housing data, but because of their different calculations, housing makes up a much larger portion of the consumer price index: about 33 percent, versus about 15 percent for the PCE

The CPI’s high housing share comes from two sources. “Primary residence rent” measures how much people spend on rental housing and accounts for about 8 percent of the total inflation index. The “owner equivalent rent” metric, which estimates the cost of renting condominiums, accounts for a much larger share of 25 percent.

You may be wondering: Why is the government using this complicated housing measure when it would be easier to just measure house price growth? The answer is: houses are an investment. Calling their price increases “inflation” would be like saying a rising stock market is “inflation.”

But houses are not just an investment. Housing is also something we consume, and when the owner lives in a house, he forgoes the financial opportunity to rent it out. To determine the “consumption value” of owning this house, the government tries to figure out how much it would cost to rent it.

The government essentially uses a two-step process to determine housing cost inflation. Step 1: Figure out how much weight rent and owner’s rent should have in the inflation index compared to everything else consumers buy. Step 2: Find out how much rents are actually rising.

Step 1, the weighting, is based on two survey questions: If you are an owner, how much could you get if you rented out your house or apartment? And if you rent, how much do you pay?

Step 2, the price change, is based on actual rental data. The government collects data from a rolling sample of rental properties and checks each unit every six months to see if the landlord is charging more. (Adjustments are made to these numbers: for example, single-family homes have more weight in the owner equivalent size because condominiums are more of a home than an apartment.)

Combine the weight with the price change and you have your real estate contribution to inflation. In real estate, consumer price index inflation was 3.5 percent in March. If you subtract the real estate market and rebalance the index accordingly, inflation that month would have been about 2.4 percent.

Housing inflation is clearly a key reason why inflation remains high.

Economists have been waiting for housing-driven inflation to ease more. Market data compiled by companies like Zillow and new lease data compiled by the government both show that rent increases on newly leased space have slowed sharply over the past two years.

But inflation indices measure all apartments, not just newly rented apartments. When market rents spiked in 2021, not all tenants immediately saw their rents increased to higher levels: landlords gradually converted leases to higher prices, causing that earlier increase to slowly fade into the official data on real estate inflation.

Forecasters expected the catch-up process to come to a halt in 2023 and 2024, causing housing costs and overall inflation to fall significantly. But the convergence between new and existing rent increases is taking significantly longer than expected.

Economists still believe there will be a ripple effect, but they are less confident about how quickly it will happen and how large it will be. And some are watching nervously as some metrics for new home rents show signs of rising again. A rental measure tracked by research firm Zelman & Associates is also showing early signs of renewed strength.

“If you had asked me six months ago, I would have said, yes, they need to get closer,” said Mark Franceski, managing director at Zelman. “With every month that went by and nothing happened, I lost confidence.”

Since today’s housing inflation is essentially catch-up inflation, some economists think we should overlook it. In Europe, some point out, the main measure of inflation does not exclude owner-occupied housing at all.

But while the measure has drawn a lot of criticism for being “fake,” “inflationist,” or based on the common (but false) claim that it comes from a dubious survey, some economists are sticking with it.

“Let me break with the youth and defend OER,” said Ernie Tedeschi, who was until recently chief economist on the White House Council of Economic Advisers. On the one hand, it is important to stick to the inflation indicator that you started with, he said. Shifting the goalposts could undermine public confidence in the Fed’s commitment to fighting inflation.

Mr. Tedeschi also emphasized that the OER is trying to get to an important idea. As the value of living space changes over time, it shapes our economic life.

For example, if a homeowner were to move and have to pay rent, it would be more expensive. (Europe is working, where it is worthwhile, to develop its own measurement of the cost of owner-occupied housing, expressly because it is an important component of inflation.)

Just as hard-to-measure forces in physics are critical to how the universe works, Mr. Tedeschi said, the value we get from where we live is hugely important to how the economy works — even if it’s complicated.

“OER is, so to speak, the dark affair of economics,” he said.

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2024-05-15 09:03:13