Part #3 of our inflation series
Another month, another record high notch in the Consumer Price Index, aka inflation level (as we discussed last time). Consumer prices increased by 5.7% over the last year, the most in over three decades. The price of everything has been rising, but leading the way, as usual, is home prices. They are up by a record 29% since last year; 3.5% over the last month alone.
Are you thinking that something seems off with these numbers? How can it be that inflation is under 6%, while the price of a home - the biggest expense many Canadians are facing - has increased by nearly five times that? We’re with you, something fishy is going on here…
Unfortunately, that fishy smell wasn’t enough to capture attention in the 2022 Federal Budget, released on April 7.
Making life more affordable was highlighted as a primary Budget goal, on which the government plans to act by investing more in housing, child care, medical care and income support for seniors. Although rising inflation may have helped motivate these commitments, fundamental problems with the way in which Canada measures inflation - and the contribution of housing prices to it - were overlooked. This failure to fix our mismeasurement of inflation means that policy decisions will continue to be made based on misleading data, harming governments, businesses, and consumers.
What’s the source of our (mis)measurement of housing inflation?
To better understand the discrepancy between inflation and home prices, let’s explore how the Consumer Price Index (CPI) is constructed.
CPI measures inflation by tracking the changes in the price of a basket of goods and services. This basket contains a variety of components, like food, transportation, clothes, and shelter. Each component receives a weighting within the basket, meant to represent how much of a typical household’s budget goes towards that category of expenses. For example, food makes up 16% of the basket, while clothing represents 4%. Shelter, the component intended to reflect housing costs, has the highest weighting at 30%.
The fact that shelter is the largest chunk of CPI means that the index isn’t failing to reflect rising home prices simply because shelter costs are neglected. At 30% of household expenditures, shelter costs are front and center.
Instead, the problem lies in how the shelter component itself is calculated. That means we need to dive deeper into the construction of the shelter component to understand what it consists of.
Statistics Canada provides a detailed (if somewhat dated) description of the shelter component of CPI. For our purposes, it’s enough to understand that shelter has three parts: owned accommodation, rented accommodation, and utilities. Given our focus on home prices, we’re most concerned with owned accommodation. This is the largest subcomponent of shelter, representing 20% of the total index.
Surprisingly, owned accommodation has increased by only 6.1% over the last year - far less than the 29% increase in housing prices. This begs the question…
What is the owned accommodation component measuring, if not home prices?
Bear with me here, we need to go just one step further to answer this question.
The main elements in owned accommodation are mortgage interest cost, and homeowners’ replacement cost.
Mortgage interest cost is the cost of a mortgage excluding principal payments (principal is the portion of a mortgage payment that goes toward the original amount of the loan owed). Shockingly, this component is down 6% over the last year, despite the fact that the both factors that determine mortgage interest costs - property values and interest rates - rose. The reason why mortgage interest costs seemingly have nothing to do with current economic conditions is that Statistics Canada uses a long-term moving average of interest rates to calculate mortgage interest costs, rather than current interest rates.
The second element of owned accommodation, homeowners’ replacement cost, represents the cost to upkeep a home at its current value. Because homeowners’ replacement cost is influenced by average home prices, it rose substantially over the last year, by 13%. However, the 6% drop in mortgage interest cost offsets much of this increase, explaining why the owned accommodation component increased by just 6.1% overall.
So, what does our analysis of the owned accommodation component allow us to conclude about why CPI is so disconnected from the housing market? Here’s the key takeaway: Nowhere are property values directly incorporated into CPI.
Inflation does not factor in the actual price of homes - only the cost of financing and maintaining a home already owned
Property values influence a few of the components of CPI, but only slightly. This might be surprising, but it is in fact by design. CPI was built to ”measure the impact of price changes on a selection of costs specific to existing homeowner”. In other words, CPI only measures costs for people who already own a home.
A good inflation gauge would represent the experiences of all Canadians. However, Canada’s inflation measure (CPI) was designed in such a way that it completely ignores a huge piece of the costs prospective homeowners are facing, i.e. rising property values.
The result of relying on an inflation indicator that ignores the experiences of Canadians who have yet to purchase a home is a lopsided approach to housing and monetary policy. The circumstances facing renters and aspiring homeowners are not considered in many policy decisions, including the setting of interest rates. A more comprehensive inflation measure that accounts for the skyrocketing increases in property values we have witnessed in recent decades likely would have called for higher interest rates many years ago, helping to cool the housing market.
We can’t continue to repeat our mistakes, using an inflation measure that is sending the wrong signals to our leaders and policymakers. That’s why Gen Squeeze is pushing Statistics Canada to remedy its mismeasurement of housing inflation.
See here for a detailed explanation of the relationship between inflation and interest rates, and here for our report with recommendations to Statistics Canada on how to begin dealing with this issue.