Jonathan Athow writes about including owner occupier housing costs in consumer price inflation and explains why ONS has decided to use the rental equivalence method to estimate them.
One of the key economic statistics that the ONS produces is inflation, the change in prices of goods and services. A particularly challenging issue in inflation measurement is housing costs for home owners. This is difficult both conceptually and in practice, and can also be controversial.
For many goods and services, it is easy to measure the price. When I buy a cup of coffee and pay £1, then that is the price. If the price of the cup of coffee goes up, then I am worse off (other things equal). This is all very straightforward: the payment and the price are the same thing. But it is not the same for areas such as housing.
One difficulty with housing costs can be illustrated with the following example. Take two identical houses sitting side by side, both purchased for £200,000. Alice buys one of the houses for cash, while Ben buys the other house using a mortgage. Both Alice and Ben are getting the same benefit (or consuming the same ‘housing services’ to use the economic language) from the houses as they are identical and cost the same. But the payments they make will differ significantly: one is making monthly mortgage payments, and the other is not. In this case, unlike the cup of coffee example, it is not obvious the payments made here are a good reflection of the price of housing.
Let us extend this example a little. Say Ben decides to remortgage his house to pay for a new, top of the range motorbike (which we will put down to a mid-life crisis). This will mean Ben’s mortgage payments go up, but this is nothing to do with higher housing costs. Rather it is just a change in the way Ben is financing his consumption of goods and services.
This reflects a fundamental challenge: we need to distinguish the price of a good or service from the way it is financed. For this reason mortgage interest payments are not necessarily a good measure of housing costs.
“Rental equivalence allows us to address the problem that a house is both an asset and a place to live.”
Directly measuring house prices is also not a good way to measure the costs of housing because a house is both an asset you own and a place to live. If the price of an asset goes up, it makes you better off. This is quite different from the price of goods and services, where as we noted above, higher prices make you worse off. So to make sure we are measuring the price of the consumption of goods and services, we need to separate out the asset price and the cost of ‘housing services’.
The approach to measuring the price of owner occupied housing that the ONS favours is known as rental equivalence. This values the ‘housing services’ you get from your house by looking at what it would cost to rent an equivalent property. This is based on the idea that if you did not own a house, you would need to rent one. Or alternatively, by living in the house I own, I am forgoing the rent I could charge. Therefore the equivalent rent is a good proxy for the costs of housing for owner occupiers.
Rental equivalence allows us to address the problem that a house is both an asset and a place to live. This approach essentially allows us to separate the ‘housing services’ element of a house, as measured by the equivalent rent, from its asset price. We can then focus measures of inflation on the changing price of those ‘housing services’.
The rental equivalence approach needs lots of data on rents to be able to match owner occupiers’ properties to similar properties that are rented. Luckily, there is a source of data within Government: namely the hundreds of thousands of rental prices collected by the Valuation Office Agency and its equivalents in the devolved administrations. These can then be matched to the stock of owner occupied homes to estimate owner occupiers’ housing costs.
We can then use the equivalent rent to measure the price of housing for owner occupiers. This gives us a way of measuring owner occupiers’ housing costs to be included in our measure of inflation.
The ONS continues to monitor different ways of measuring housing costs, and has just published an analysis of how the different approaches would affect the CPIH: https://www.ons.gov.uk/releases/understandingthedifferentapproachesofmeasuringowneroccupiershousingcostsoohweightsanalysis
This shows that taking an average over the last 4 years, using one of the other methods for estimating owner occupiers’ housing costs would only shift the inflation rate by an average of 0.1 percentage points.
Jonathan Athow is the Deputy National Statistician for Economic Statistics