Reforming the RPI: a better treatment of the housing costs? (Retail Price Index)

Summary

Difficulty of measuring housing costs

The Retail Price index (RPI)) measures inflation. Its purposes is to tell us by how much a person's income would need to be increased in order to maintain a constant level of consumption of goods and services. These include shelter (housing services), an important element in most people's budgets. There seems little doubt that housing costs should be included, one way or another, in the RPI.

In a market economy there is relatively little difficulty in measuring the price of housing services, which is given by the rent that a landlord charges for providing accommodation. A rise in average rents represents (ignoring possible changes in the quality of the services provided) a rise in price.

The problems start when landlord and occupier are the same person: there is a consumption of housing services but no measurable rent. Statisticians respond by imputing a rent to the owner-occupier equal to the actual rent charged in comparable properties on the open market. However in the United Kingdom this approach does not work because the market in private rented property is small and distorted by controls.

The present method: interest payments as proxy for imputed rents

For this reason mortgage interest payments, which are the main cost of housing to owner-occupiers, are currently used as a proxy for imputed rent in the construction of the index. There are three problems with this approach: 1. Only one-quarter of the value of the average house is mortgaged, and to this extent interest payments understate the full rental value of the service provided, (and hence its weight in the index). 2. Houses can rise in value and this important offset to the interest cost of servicing the mortgage is not taken into account (thus overstating its weight in the index). 3. Mortgage payments depend on the value of the stock of mortgages, which in turn depends to a large extent on past house prices. These may bear little relation to the current value of housing services which we are trying to measure.