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

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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Publication:Monthly Labor Review
Date:Feb 1, 1985
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