Over the past year or two even the mainstream media seems to have had flickers of realisation about the problems with official inflation measures. Perhaps their journalists wondered how things could be so expensive with recorded inflation so low? I recall even Bloomberg publishing pieces on exactly that looking at problems in the housing situation in Germany which expressed exactly that with those experiencing reality questioning the official numbers and in more than a few cases suggesting they came from a place far,far away.
Yesterday a member of the Executive Board of the ECB expressed his worries about this area, So let us look at what Yves Mersch had to say.
A prolonged loss of trust in the ECB risks undermining the broad public support that is necessary for central bank independence.
I think he is going a bit far with “broad public support” as most people will only have a vague idea about what the ECB does but let us indulge Yves for now. He goes onto ground which is about as near as central bankers get to admitting the amount of mission-creep that has gone on.
This is of particular concern when the range of non-conventional measures brings monetary policy closer to the realm of fiscal policy and the institutional effects of these policies are becoming more pronounced.
House Prices
This follows a section where he points out this.
The risks arising from strong housing price inflation extend beyond financial stability.
Indeed although the Euro area had lots of problems for financial stability as pre credit crunch house prices in Ireland, Spain and the Baltic States boomed and later bust, which also undermined many banks. However in spite of this he confesses that one way of guarding against this happening again has been ignored.
At present, owner-occupied housing costs are not included in the Harmonised Index of Consumer Prices (HICP) that is used to formulate our inflation aim of below, but close to, 2% over the medium term.
I mean why would you put in something which for many is their largest monthly expenditure? The next sentence covers a lot of ground but the latter part is very revealing.
There are a number of technical explanations for this exclusion, but it is clear that households view the cost of housing as an important part of their lifetime expenditure.
“View”?! The truth is that if we switch to describing it as shelter it is a basic human need. Of course central bankers have a track record in downplaying basic human needs in the way that food and energy are left out of so-called core inflation measures, but this takes things a step further as many of the costs of shelter are completely ignored rather than downplayed. As to the “technical explanations” let us just mark them for now as I will cover them later.
Next we get another example of the central banking obsession with rents.
Rents represent around 6.5% of the basket used for measuring inflation.
Let me explain why. This is because in their Ivory Tower world people consume housing services whatever they do. This works for those who do rent as their (usually) monthly payment fits with that theory. Actually in practice there are more than a few problems with measuring this accurately as I noted earlier in the reference to Bloomberg Germany in particular. Also there are a lot of complaints concerning Ireland too. So even where it should work there are troubles,
But when you apply consumption of housing services to people who buy their own home be it outright or via a mortgage there is trouble. If someone is fortunate enough to buy outright then you have one large payment rather than a stream of services. Even the highest Ivory Tower should be able to spot that this simply does not work. You might think that using mortgages would work much more neatly after all a monthly payment does have some sort of fit with consuming housing services. But for a central bank there is a problem as it is the main player in what the monthly mortgage costs is these days. In the case of the ECB its negative deposit rate of -0.5% and its QE bond buying operations ( currently 20 billion Euros per month) have reduced mortgage rates substantially.
So there is the “rub”. Not only are they reducing the recorded level of inflation with their own policy which is of course trying to raise inflation! But even worse they are raising house prices to do so and thus inflation is in fact higher. It is not the misrepresentation or if you prefer lying that bother them as after all they are practised at that but even they think they may struggle to get away with it. In a way the speech from Yves reflects this because the background to all this is below.
House prices rose by 4.1 % in both the euro area and the EU in the third quarter of 2019 compared with the same quarter of the previous year.
You see why they might want to keep house prices out of the inflation index when we note that the official HICP measure recorded 1% (twice) and 0.8% in that same quarter.
Yves continues the official swerve with this.
Indeed, the United States, Japan, Sweden and Norway already integrate owner-occupied housing into their reference inflation indices.
You see both Japan and the United States use rents as a proxy for owner-occupied housing costs in spite of the fact that no rents are paid. You might think when Yves has noted the influence of house prices he would point that out. After all using fantasy rents to measure actual rises in house prices will only make this worse.
The gap between perceptions and official measures of inflation can complicate the communication of policy decisions. If households believe that inflation is rampant then they will see little justification for unconventional measures, in particular negative interest rates.
There is no little arrogance here in “believe that inflation is rampant” to describe people who have real world experience of higher prices and hence inflation as opposed to sticking your head in the sand for two decades about an important area.
Comment
Even Yves is forced to admit that the omission of owner-occupied housing costs has made a material difference to recorded inflation.
If it were to be included in the HICP, it could raise measured inflation rates in the euro area by around 0.2 to 0.5 percentage points in some periods. Taking that into consideration, core inflation would lift from its current 1.3% to its long-run trend, or even higher, thereby having a bearing on the monetary policy stance.
You can bet that the numbers have been absolutely tortured to keep the estimate that low. But this also hides other issues of which Eurostat provides a clear example below.
the annual growth rate of the EU HPI reached a maximum of 9.8 % in the first quarter of 2007
Pre credit crunch Euro area house prices did post a warning signal but were ignored. After all what could go wrong? But more recently let me remind you that the ECB put the hammer down on monetary policy in 2015.
Then there was a rapid rise in early 2015, since when house prices have increased at a much faster pace than rents.
Or to put it another way the Euro area HICP is full of imagination.
Could it be that it’s just an illusion?
Putting me back in all this confusion?
Could it be that it’s just an illusion now?
Could it be that it’s just an illusion?
Putting me back in all this confusion?
Could it be that it’s just an illusion now?
I promised earlier to deal with the technical issues and could write pages and pages of excuses, but instead let me keep it simple. The consumer in general spends a lot on housing so they switch to consumption where purchase of assets is not included and like a magic trick it disappears. Hey Presto! Meanwhile back in the real world ordinary people have to pay it.