The effect of rental equivalence on the Consumer Price Index, 1967-82 Essay

In 1983, the Bureau of Labor Statistics converted to a rental
equivalence measure for homeowners’ costs in order to remove the
investment aspect from the Consumer Price Index for All Urban Consumers.
This note provides an estimate of the effect which this change would
have had on the CPI-U during 1967-82, when the prices of houses rose
sharply.



Under the new measure of homeowners’ costs, the index would
have increased by 165 percent. By contrast, the official CPI-U climbed
by almost 188 percent during the 16-year period.



In essence, the change converted the homeownership component from a
method that included investment as well as consumption elements to a
flow-of-services approach that measures only the cost of shelter
services consumed by homeowners. The flow-of-services approach uses a
technique that estimates the change in the cost of renting housing
services equivalent to those provided by owner-occupied homes.



The change in the index followed many years of recommendations and
research by BLS staff and by other government, academic, business, and
labor economists and statisticians. The Bureau conducted extensive
research on measuring shelter cost for homeowners as part of the program
that led to the comprehensive revision of the CPI in 1978. From these
efforts came a BLS staff proposal to change the treatment of shelter
costs in the CPI to a flow-of-services approach. This proposal was
widely reviewed and discussed. However, difficulties in developing a
workable flow-of-services measures and the diversity of views held by
various advisory groups led to the decision not to change the
component’s concept at that time.


In 1980, the Bureau introduced five experimental measures (known as
the CPI-U-X1 through the CPI-U-X5) to demonstrate the effect different
homeownership concepts and techniques could have on the All Items CPI.
The experimental CPI-U-X1, which used a rent substitution technique, is
the direct (although approximate) antecedent of the method the Bureau
has now adopted. The development of the CPI-U-X1 increased confidence
in the workability and credibility of a rental equivalence measure.



Limitations of the CPI-U-X1



Because the CPI-U-X1 was computed outside the CPI production system
by restructuring indexes of major national price groups, it lacked the
precision and detail and, more importantly, the proper local area
weighting of the official CPI. Further, the five homeownership items of
the old method–home purchase, contracted mortgage interest cost,
property taxes, property insurance, and maintenance and repairs–were
simply replaced in the CPI-U-X1 by a single, new homeownership item.
The weight for this new item was computed using a rather imprecise,
short-cut technique from homeowners’ estimates of what their homes
would rent for, as reported in the 1972-73 Consumer Expenditure Survey.
Finally, the price movement used for this item was the price movement of
the U.S. residential rent index.



BLS addressed these limitations of the CPI-U-X1 for the 1983
conversion to rental equivalence. First, the new index was computed
from local area item-strata cost weights. This process provides the
precision, complete item and geographic detail, and proper geographic
weighting associated with the official CPI. Second, new expenditure
weights were calculated by means of the complex statistical estimating
procedures used throughout the CPI. As described below, weights were
calculated for a new primary homeownership item, homeowners’
equivalent rent, and recalculated for household insurance, maintenance
and repairs, and house appliances. Third, a new set of statistical
weights for the sample of rental units was calculated so that its price
movements could represent owner-occupied housing units as well as
renter-occupied units. Finally, the rent sample was augmented, in part
by adding sample units in areas with high owner occupancy. This made
the sample more efficient for measuring changes in owners’
equivalent rent, and the increased sample size reduced the expected
errors of both the renters’ data and the owners’ estimates of
price change.


To address the question of how different the CPI-U-X1 would have
been had the 1983 refinements been used in its calculation, BLS
constructed an enhanced X1. Unfortunately, it was not feasible to
replicate all of the enhancements. In particular, recalculating a price
change measure from an augmented and reweighted rent sample was beyond
the scope of this project. Local area price changes for
homeowners’ costs reflecting the reweighting, but not the
augmentation, of the rent sample were available from some test runs of
the new procedures starting with data for June 1980. It was not
practical to perform calculations for earlier periods. Nor was it
practical to produce the full index with its full calculational
precision. The enhanced X1 presented here–like the original–was
produced using a method that averages together indexes with relative
importances for weights. However, except for the extensive numeric precision and the item and geographic detail of the official
calculation, the special technique does yield accurate recalculated
indexes. The first step in calculating an enhanced X1 was to compute a
U.S. rental equivalence index for the 1967-82 period. This index used
the proper weighting among local areas and, from June 1980 forward,
rental change measures from a sample weighted to represent homeowners,
instead of renters.



The local area indexes were averaged together using the local area
weights for owners’ equivalence of rent that were developed for the
1983 CPI-U to produce a national rental equivalence index from the base
year 1967 to 1982. Compared to the rent weights, owners’
equivalent rent shifts weight from the larger metropolitan areas to the
smaller. The three largest local areas account for 29.9 percent of the
rent weight but only 21.7 percent of the owners’ equivalent rent
weight, mostly because of the large difference in the New York standard
metropolitan statistical area. The CPI geographic areas that represent
smaller urban areas have 40.7 percent of the rent weight and 49.5
percent of the rental equivalence index. Renting is more common and
more expensive in large areas.



As shown in table 1, the differences between the changes in the
rent and owners’ equivalent rent indexes were surprisingly small.
Reweighting the local area, at least, seems to have no discernible effect, although the change over the 16-year period was slightly smaller
for owners’ equivalent rent. Reweighting the rent sample itself
may have some effect. The largest difference between the two series
occurs in the last period, the only period in which the full effect of
the sample reweighting is present. The Bureau, however, does not have
enough information about sample reweighting (and none at all about
sample augmentation) to be able to demonstrate any difference
conclusively.



The next step toward enhancement was to combine the new index of
rental equivalence with other CPI series to obtain an all-items index.
The original CPI-U-X1 was an aggregate of the seven major groups of the
CPI (food and beverages, housing, apparel and upkeep, transportation,
medical care, entertainment, and other goods and services) less
homeownership (which was part of the housing group) plus the rent
substitution item. The price movement of the rent substitution items
was taken from the national rent index. The enhanced X1 combines a new
housing group with the six other major groups. The housing group is an
aggregation of eight items: rent, other rental costs, owners’
equivalent rent, household insurance, maintenance and repair services,
maintenance and repair commodities, fuels and other utilities, and
household furnishings and operations. A small adjustment was made to the
weight for household appliances to compensate for the cost implicity
counted in the owners’ equivalent of rent. Table 2 shows the
components used to construct the CPI-U-X1 and the enhanced X1, as well
as the weight of each. Although there are more components for housing in
the enhanced X1, the 1983 refinement of the item weights had very little
effect on the distribution of weight among the major groups. Note that
the weight for housing in the CPI has been reduced from almost 49
percent to about 38 percent.



The results of this study are shown in table 3, which compares the
enhanced X1 with the CPI-U-X1 and the CPI-U. From 1967 to 1982,
differences between the enhanced X1 and the CPI-U-X1 are few and
negligible compared with the differences between either and the official
CPI-U.

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