Would Eurozone Inflation Be Higher If Housing Costs Were Correctly Accounted For?

There is a perception that inflation in the eurozone is underestimated because of the inadequate accounting of housing costs. While inflation could have been marginally higher in the past few years if housing were given a more realistic weighting, the methodological issues are far from resolved

A renovated row of houses in Berlin

During the European Central Bank's Q&A session after the monetary policy meeting in January, the topic of real estate prices was raised as a possible issue to be examined during the Strategic Review. There is the feeling that the current HICP methodology doesn’t sufficiently take into account housing costs, which to some extent explains the difference between the inflation rate and perceived inflation. Executive Board member Yves Mersch also elaborated on this topic in a recent speech, pointing to the small weighting of rents in the inflation basket, and also noting that for many, rents alone or mortgage payments easily exceed a third of their take-home pay.

The cost of living in your own house

In the HICP measure of inflation only “actual rentals for housing” are included, which accounts for about 6.5% of the inflation basket. Of course, as many countries have a high degree of house ownership, rental expenditures are only part of the consumption basket for a smaller percentage of the population. This also implies that the feeling of high housing costs for a majority of the population derives from high real estate prices rather than from the level of rental costs (though they readily forget that the financing cost for acquiring a house has tremendously declined). However, a consumption price index is not meant to include asset prices. That's basically the reason why some countries (the US being a notable example) have added a measure of owner-occupied housing (OOH) costs to their consumption basket. This can be seen as the theoretical cost to live in your own house. Some statistical offices compute this using the rental income for equivalent houses. Other countries use more complicated methods where they separate the cost of the land (asset) from the cost of the housing structure (the consumption good).

Weak rental cost inflation

The question is whether adding the owner-occupied housing (OOH) costs to the consumption basket would make a big difference to inflation. A number of ECB critics clearly think that inflation is significantly underestimated. However, we should be very cautious in assessing the impact of high real estate prices on the cost of living. Actually, over the past few years, trends in real estate prices and rental prices have clearly diverged. This is logical, as the fall in bond yields also implies a lower required rental yield on residential property. In a number of countries, rents are indexed or controlled, which also contributes to weak rental inflation. Therefore, an owner-occupied housing cost computed according to the rental equivalence approach would not have made that big a difference in terms of overall inflation. Since the start of the Monetary Union, average rental price inflation has been 0.1 percentage point lower than average headline inflation, while over the last 10 years it has been 0.05ppt higher. The difference has been somewhat bigger at 0.2ppt over the last five years.

Rental cost inflation

Source: Refinitiv Datastream

Would it matter?

Eurostat has been working on experimental OOH prices, provided by EU national statistical institutes. In 2016, the ECB calculated the potential effect of including the national OOH indices into the euro area HICP. It implied absolute differences in the inflation rates of up to 0.2 percentage points in any individual quarter. But the average inflation over the five years under review didn’t change. However, according to other research, the downward bias of excluding OOH costs from the inflation basket could be up to 0.5ppt.

Little short-run impact

So the jury is still out as to how big a difference it would make if housing were a bigger chunk of the inflation basket. These reflections are likely to be part of the ECB’s strategic review, but the matter is not going to be resolved very quickly. To quote ECB President Christine Lagarde during the January press conference, “If there is a real difference, which there might well be, then we need to pass that on to Eurostat and have Eurostat do further and additional work. I'm not suggesting that it's going to be resolved in one year.” Hence, the probability that these considerations will have a material influence on monetary policy over the next year or two remains very low, although it could play a more important role in a later stage.