U.S., UK inflation gauges face housing cost distortion, analysis says

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Highlights

Rental equivalence methods for owner-occupied housing cause inflation gauges in the U.S. and UK to lag actual market conditions, distorting official data.
Replacing existing measures with new-tenancy rent inflation would show U.S. CPI returning to the Fed's target by 2023 and PCE by 2024, potentially altering rate decisions.
UK's CPIH inflation based on new rents remains above target in 2026, but the gap is smaller, suggesting persistent overstatement from current housing cost methods.

Owner-occupied housing method under scrutiny

As reported by Financial Times, the main flaw in current inflation measurement lies in the use of rental equivalence to estimate housing costs for homeowners, a method the analysis argues introduces significant distortion in both the U.S. and UK.

The article says most European inflation measures effectively treat owner-occupiers as having no housing costs, while the U.S. approach creates a substantial lag because it relies on rent-based estimates for owner-occupied homes. That lag matters because housing is typically the largest household expense and carries large weights in inflation baskets, including about 26% in U.S. CPI, nearly 12% in PCE and just over 17% in the UK's CPIH.

Under rental equivalence, statisticians ask what a homeowner would pay to rent an equivalent property and use rent data as a proxy for housing services consumed. The analysis argues the practical problem is whether to use average rents across the market or the cost of new rental agreements, and says average rents trail market conditions because many landlords adjust prices only intermittently.

The same pattern appears in both the U.S. and UK, where new tenancy rents rise and fall faster than average rents. The article says this makes official inflation data look more persistent than price pressures experienced in the wider economy.

Policy implications for central banks

Using alternative, rough calculations that replace existing rental-equivalence components with new-tenancy rent inflation, the analysis says the inflation picture changes materially. In the U.S., CPI and PCE would show a faster fall in inflation after the 2022 spike, suggesting inflation returns to the Federal Reserve's target by 2023 for CPI and by 2024 for PCE.

That result implies the Fed might have cut interest rates further and faster if it had been working with inflation measures that reflected current rental market conditions more closely, although rates might also have risen higher during the inflation surge itself. The analysis presents this as evidence that official housing measures can affect both the timing and scale of monetary policy decisions.

In the UK, the Bank of England targets CPI rather than CPIH, so policy would not have shifted directly even if CPIH mismeasures owner-occupied housing. Still, the article says a CPIH measure based on new rents would sit closer to the BoE's target measure and could make any future switch to CPIH easier, while still leaving inflation above target in 2026, though by less than current figures suggest.

The broader conclusion is that central banks should be cautious about relying too heavily on headline data without examining how those figures are constructed. The analysis argues for a revised approach to rental equivalence in the U.S. and UK, saying current methods mechanically build inflation persistence into the data.

Our earlier coverage of the UK budget watchdog’s upcoming forecast update explained that the Office for Budget Responsibility is revising its projections after inflation stayed stickier than expected following the 2022 energy shock. We noted that higher inflation risks and new geopolitical pressures could squeeze the government’s limited budget headroom, influencing both fiscal planning and the broader policy debate around inflation persistence.

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