Misconceptions about the CPI (FR Thread to Prove or Disprove CPI and Shadow Stats)(17page PDF file)

A number of longstanding myths regarding the Consumer Price Index and its methods of construction continue to circulate; this article attempts to address some of the misconceptions, with an eye toward increasing public understanding of this key economic indicator.

The Consumer Price Index (CPI), published by the Bureau of Labor Statistics (BLS), has generated controversy throughout its history. A soon-to-be-published article by Marshall Reinsdorf and Jack Triplett discusses the many past reviews of the methods and data used in the CPI’s construction.1 Beginning with an advisory committee appointed by the American Statistical Association in 1933,2 and continuing through the recent National Research Council panel chaired by Charles Schultze,3 panels and commissions have identified and discussed what is now a well-known set of issues affecting the measurement of consumer prices: consumer substitution behavior, change in the quality of products, the introduction of new types of goods and services, and the appearance of new categories of stores and new channels of product distribution. Given the large number of private and public uses of the CPI, and especially its important role in determining Federal Government revenues and payments, it is natural that each of those issues has been the subject of intense public attention.

Official US Deficit Put At Staggering $202 Trillion

Posted by EU Times on Aug 25th, 2010 // 7 Comments

The Congressional Budget Office (CBO) forecasts the U.S. budget deficit will hit $1.3 trillion this year. An astronomical figure, to be sure, but that’s lower than was projected in March. It’s also less than last year’s record $1.41 trillion deficit, which was close to 10% of GDP.

And, that’s the good news.

As the deficit grows so does the national debt, which is currently more than $13.3 trillion, according to official figures.

But the situation is actually much, much worse, according to Boston University economics professor Laurence Kotlikoff.

“Forget the official debt,” he tells Aaron in this clip. The “real” deficit – including non-budgetary items like unfunded liabilities of Medicare, Medicaid, Social Security and the defense budget – is actually $202 trillion, the professor and author calculates; or 15 times the “official” numbers.

“Congress has engaged in Enron accounting,” says Kotlikoff, who recently penned an op-ed for Bloomberg entitled: The U.S. Is Bankrupt and We Don’t Even Know It.

Yet, the debt market continues to have an insatiable appetite for U.S. Treasuries; heading into Monday’s session, the yield on the 30-year Treasury bond (which moves in opposition to its price) was at its lowest level since April 2009.

Kotlikoff says that’s because the market is focused on the “mole hill” of official debt. In time, the U.S. will have a major inflation problem to rival that of Germany’s post World War I Weimar Republic, he predicts. “We have to think about the fact that unless the government gets its fiscal act in order we’re going to have the government printing lots and lots money to pay these enormous bills that are coming due over time.”

America is in need of major reform of the health-care, retirement, tax and financial system, Kotlikoff continues. “We need (to perform) heart surgery on this economy, not putting on more band-aids which is what we’ve been doing.”

Barring that, your hard-earned dollars will soon be worthless, he declares.

Bringing Professor Gordon’s synopsis to the fore:

The Boskin Commission Report: A Retrospective One Decade Later*

Abstract
This paper provides a retrospective on the 1996 Boskin Commission Report, Toward a More Accurate Measure of the Cost of Living, and its famous estimate that the CPI in 1995-96 was upward biased by 1.1 percent per year. The paper summarizes the report’s methods, findings,and recommendations, and then reviews the comments and criticisms that appeared soon after the Report was issued. Changes in the CPI are summarized and assessed, as is recent research on related issues. The paper sharply distinguishes two questions. First, with what we know
now, what should the Commission have concluded about CPI bias in 1995-96?

Second, what is the bias now after the many improvements introduced into the CPI since the Commission’s Report?

About the first question, my own recent research on apparel and rental housing indicates a substantial downward bias in the CPI over much of the twentieth century,diminishing in size after 1985. Incorporating these findings into the Boskin matrix would reduce its 0.6 percent annual upward bias due to quality change and new products to a smaller
0.4 percent bias. However, this is more than offset by the stunning discrepancy over 2000-06 in the chain-weighted C-CPI-U compared to the traditional CPI-U, indicating that the Commission greatly understated the magnitude of upper-level substitution bias. This retrospective evaluation suggests that the Boskin bias estimate for 1995-96 should have been 1.2 to 1.3 percent, not 1.1 percent.

Current upward bias in the CPI is estimated to have declined from the revised 1.2-1.3 percent in the Boskin era to about 0.8 percent today. Yet the Boskin report, like most
contemporary studies of quality change, failed to place sufficient value on the value of new products and on increased longevity. Allowing for these, today’s bias is at least 1.0 percent per year or perhaps even higher.

Keywords: inflation, price measurement, substitution bias, quality change, new products, medical care
JEL Codes: I1, I11

Robert J. Gordon
Department of Economics, Northwestern University
Evanston IL 60208-2600
(847)491-3616
rjg@northwestern.edu
http://faculty-web.at.northwestern.edu/economics/gordon

Uncle Miltie,

I wanted to get this out to you now; I just have time for a few comments on the fly; busy weekend

The article ‘Addressing misconceptions about the Consumer Price Index’ by John S. Greenlees and Robert B. McClelland lists what it labels as common misperceptions about the CPI and does a poor job of refuting them.

“that Social Security payments are indexed to a CPI that does not include food or energy”:
Neither myself nor Williams has claimed that Social Security payments are indexed by a CPI that excludes food and energy.

“that the 1983 change in the way the BLS measures homeownership costs lowered the rate of increase of the CPI; “
The fact that the public often mistakenly believes this is understandable since both the media and the Fed point to core inflation to demonstrate how the effectiveness of monetary policy in keeping inflation low.

Recently the president of the NY Fed, William Dudley gave a speech cheer leading for how low inflation is, in which he stated “The Fed looks at core inflation, which strips out volatile food and energy costs, to get a better sense of where inflation may actually be heading.”. Dudley then gave the example of how "Today you can buy an iPad 2 that costs the same as an iPad 1 that is twice as powerful,"

“that the 1983 change in the way the BLS measures homeownership costs lowered the rate of increase of the CPI;”
As to the rent, see Post # 11 here. I don’t have time to re-research this item now. IIRC under Reagan ‘rent equivalence’ was introduced to weight the actual costs of home ownership and purchase using ‘rent equivalence’.

“that the BLS lowers the CPI to reflect consumers’ substitutions of hamburger for steak;”:
This statement is the next best thing to a lie. It is downright misleading. The Boskin report, cited frequently by the BLS, actually uses the substitution of chicken for steak as one of its justifications for hedonics adjustments, quality adjustments, substitution adjustments using geometric weights. While the Boskin Report did not use the actual words hamburger for steak, the concept is the same! Reminds me of the renaming of man made global warming to climate change.

Here are some examples of the substitution effect, hedonics, and quality change in action:

A walk through of the adjustment to price of a new TV is found here here.

A 27” CRT TV which is no longer available is replaced by its nearest equivalent a 42” flat screen. There is a –7.1% quality adjustment to the price used in calculating the CPI.

"A quality adjustment has been made to gasoline prices used in the January CPI to account for the effects of the mandated introduction of reformulated gasoline in selected areas of the United States. The gasoline index rose 0.4 percent in January, following seasonal adjustment. Without the quality adjustment, it is estimated that this index would have increased 1.1 percent.."

There is a -.7% quality/hedonic adjustment of federally mandated changes to the price used in calculating the CPI

I recently had to replace an old refrigerator. I bought the closet equivalent which uses the new and more expensive federally mandated coolant that replaced Freon. There will be an -n% quality/hedonic adjustment of federally mandated changes to the price used in calculating the CPI.

Now in the real world, the consumer pays the full price of the flat screen tv, not the full price –7.1%. The consumer pays the full price for gasoline, not the full price of gasoline -.7%. I paid the full price of the new refrigerator, not the full price of the refrigerator –n%. When a consumer who normally buys steak, substitutes hamburger or chicken or Spam because the cost of steak has risen to the point where he can no longer afford it, inflation has lowered his standard of living.

Changes in taste, quality, and the substitution of lower priced goods for higher priced ones were once accommodated by periodic surveys and arithmetic weighting.

So it all boils down to a simple concept. Does the CPI reflect inflation or the Consumer Price Index as accurately as it did before the introduction of the soft metrics of substitution, hedonics, quality adjustment using geometric weighting. Reality based common sense says that it does not.

Now a word about the BLS and definitions.
Over time the BLS has changed the definition of the CPI from being a Consumer Price Index to being a ‘Cost of Living Index’.

Per the BLS, a Consumer Price Index measures a price change for a constant market basket of goods and services from one period to the next within the same city (or in the Nation, whereas a Cost of Living Index measures differences in the price of goods and services, and allows for substitutions to other items as prices change.

In addition the BLS has its own special definition of a Cost-of-Living-Index’, to wit it accommodates for the substitution effect described in the Boskin Report. Perhaps a better word is Cost-of-Existing Index. Talk about what is the meaning of is!

IMO and experience Shadow Stats charts more closely represent inflation. Considering how the FDA and EPA, two government agencies that in theory are run on scientific considerations have been corrupted by political considerations, why would the BLS be exempt? The BLS is a unit of the Department of Labor, which is a cabinet department whose head serves at the pleasure of the current administration. It is staffed with the same ilk that staffs the EPS and FDA- career academics with no real life reference point.

Some of the relevant links are found here and here.

Re post #http://www.freerepublic.com/focus/news/2703730/posts?page=31#31 , it is a modification of post #35 which is in response to this post.

Reality Calls. Will check back.

Non-sequential thoughts on what does and doesn't make sense in the BLS CPI index:

It makes sense to exclude extremely volatile items from Core CPI, as it would make it difficult to evaluate from month to month or Y-o-Y, whether the spike or fall in market prices of energy and food staples are temporary (due to crop drought or weather anomalies, geological conditions, geopolitical upheaval(s), industrial accident(s) etc.) or more permanent developments. The good thing is, that if energy cost is more "permanent" (let's say, stays at a "new normal" level for 3-6 months. it tends to seep into and be reflected in the prices of consumer products (including food) due to costs associated with production and delivery of such products...

In other words, we'll see "permanent" cost increase/decrease of generally volatile products reflected in Core CPI anyway, with some lag, after it's incorporated in the cost of the products or service, but the Core line will be smoothed over period of time, rather than sharp spike up or down or non-Core index.

Another reason it makes sense to exclude food prices from non-Core CPI is that generally they does not comprise a large percentage of household expenditures (generally, the lower the household income the more it's affected by food prices). Food and energy prices are also varied widely depending on where household is located, rural or urban areas, cities and states. However, along with gasoline (part of energy cost), it's one of the most visible and comparable costs for the U.S. households, so it generates the most heated and emotional complaints about "inflation". Food is also the most likely subject to "hedonic" substitution or even [temporary?] exclusion from the people's diet (BTW, dog/cat/pets food maybe a notable exception from this but I believe that it doesn't quite affect the CPI so it's irrelevant for this discussion).

It makes sense to use and periodically adjust "hedonic" regression / substitution, or we would still be working with the cost of buggy whips and costs of cleaning up horse manure from the streets. Yes, it's open to some political biases and influences, but likely less than generally suspected.

Buying generic label cereals or canned food, using bicycle, motorcycle, more efficient car or carpool, for example, are forms of hedonic substitution that are commonly practiced, but might be difficult to reflect in index without detailed data measuring these on a regular basis. Also, technology is a relatively constant disinflationary force, so giving it a higher weighting in the index would tend to pull index down.

Depending on the mix of the items in the BLS basket relative to what we tend to purchase (as a percentage of our income or costs) we will all see the different "realities" of COL... in other words, to people it's subjective and personal, while BLS is attempting to reflect the "average" CPI.

Also, we should not forget that recent droughts in the U.S., Australia, Africa, lingering long-term fiscal and monetary problems in certain EU countries (PIIGS) and dangerous political instability in Africa and Middle East, along with misguided politically motivated subsidies and "green" / environmental policies (not just in the U.S) have sent prices of food staples and energy (particularly oil) sharply higher in recent months. Add to that the huge inflation in China and India (and less relevant, in Brazil) which for years have been exporting deflation but are now starting to export [relative] inflation, and that the U.S. is just now coming out from the Great Recession and sharp disinflation (from about H2 of 2007 through 2010), and some inflation in the recovery ought to be expected.

BLS is doing a pretty good job of collecting data, and decent job of comprising and analyzing index, and separating Core from non-Core components. That said, no system is perfect and would satisfy everyone. Given that the data points are detailed in BLS reports, anyone can "personalize" their own "basket" of items and index it based on the weighting they want to attribute to each item, as they most affect the author of the index.

As long as we don't try to compare the today's cost of the "basket of apples" with the last year's cost of the "basket of oranges," we should do fine in proving just about anything we want, from our own view on price inflation/deflation.

There are credible attempts to create other indices that measure "price inflation" or consumer cost. Here is the most interesting recent one - MIT's BPP (Billion Prices Project) at http://bpp.mit.edu/daily-price-indexes/?country=USA

These indexes are designed to provide real-time information on major inflation trends, not to forecast official inflation announcements. We are constantly adding new categories of goods, but we do not cover 100% of CPI goods and services. The price of services, in particular, are not easy to find online and therefore are not included in our statistics.

It's a set of interactive charts of Daily Online Price Index, Annual Inflation and Monthly Inflation. Keep in mind the differences from BLS CPI, but it's exactly why it may attract some people who are suspicious about BLS CPI - it only uses online price data, data is NOT "seasonally" adjusted, BPP includes the food prices but doesn't include energy prices.

Both CPI and BPP were up significantly in the last couple of months, but not much on Y-o-Y basis.

Some references that may be of interest:

From Why inflation hurts more than it did 30 years ago | Inflation hurts more than it did 30 years ago for Americans stuck with flat income - AP via Breitbart, 2011 March 18

Inflation spooked the nation in the early 1980s. It surged and kept rising until it topped 13 percent. These days, inflation is much lower. Yet to many Americans, it feels worse now. And for a good reason: Their income has been even flatter than inflation.
Back in the '80's, the money people made typically more than made up for high inflation. In 1981, banks would pay nearly 16 percent on a six-month CD. And workers typically got pay raises to match their higher living costs. No more.
Over the 12 months that ended in February, consumer prices increased just 2.1 percent. Yet wages for many people have risen even less - if they're not actually frozen.
Social Security recipients have gone two straight years with no increase in benefits. Money market rates? You need a magnifying glass to find them. That's why even moderate inflation hurts more now. And it's why if food and gas prices lift inflation even slightly above current rates, consumer spending could weaken and slow the economy. ..... < snip >

From Inflation Actually Near 10% Using Older Measure | Inflation Using Volcker-Era Methodology Nearing 10% - CNBC, by John Malloy, 2011 April 12

< snip > ..... Inflation, using the reporting methodologies in place before 1980, hit an annual rate of 9.6 percent in February, according to the Shadow Government Statistics newsletter.
Since 1980, the Bureau of Labor Statistics has changed the way it calculates the CPI in order to account for the substitution of products, improvements in quality (i.e. iPad 2 costing the same as original iPad) and other things. Backing out more methods implemented in 1990 by the BLS still puts inflation at a 5.5 percent rate and getting worse, according to the calculations by the newsletter's web site, Shadowstats.com.
"Near-term circumstances generally have continued to deteriorate," said John Williams, creator of the site, in a new note out Tuesday. "Though not yet commonly recognized, there is both an intensifying double-dip recession and a rapidly escalating inflation problem. Until such time as financial-market expectations catch up with underlying reality, reporting generally will continue to show higher-than-expected inflation and weaker-than-expected economic results in the month and months ahead." The pay-site and newsletter by Williams, an economic consultant for the last 30 years to companies, has gained a cult following among bloggers hungry to criticize Bernanke these days. ..... < snip >
..... To be sure, the BLS argues that the changes it has made over the last three decades more accurately reflect a true change in the cost of living. For example, in response to its hedonic adjustments, the BLS web site states, "to measure price change accurately, the CPI must be able to distinguish the portion of price change due to this quality change." ..... < snip >

Here’s another approach to explaining why hedonics / quality adjustments and substitution / chained dollars put into using geometric weighting have corrupted the CPI.

According to the BLS, the CPI is the most commonly used indicator of inflation, i.e. the average change over time in the cost of goods and services.

As such it influences interest rates, the stock market, and a host of salary and pension negotiations each year. It is used by the Federal Reserve to justify its money printing policies, to set the interest rate on inflation-adjusted bonds known as TIPS, and by the federal government to calculate cost-of-living adjustments (COLA) for the entitlement programs (e.g., Social Security). The more inflation is understated, the higher the inflation-adjusted rate of GDP growth that gets reported. In addition, the CPI influences interest rates, the stock market, and a host of salary and pension negotiations each year

All these uses require an index that measures the consumer cost of a set standard of living, i.e. an apples to apples comparison.

Concepts such as hedonics, quality adjustment, substitution effect, chained dollars, and intervention analysis are all soft metrics that introduce changes to actual consumer’s cost of purchasing a fixed basket of goods. The specious changes that reflect subjective value judgments from a government agency staffed with people who have more education than common sense and real life experience. When the CPI is calculated, these value judgments determine what quality changes are worth to you, when you will substitute one item for another, which items you will substitute for one another, and when a price goes up ‘too much’.

How for instance is the mandated replacement of incandescent light bulbs with CFL’s valued? Which does life experience tell you happens: a positive quality change is determined because of the PC impact on ‘climate change’ and the CPI is adjusted downward, or a negative quality adjustment is determined because of mercury added to land fills, increased electric usage for those places where lights are routinely only turned on briefly, increased headaches and even seizures in those who are sensitive to the flicker inherent in CFL’s and the CPI is adjusted upward?

How do the mandated low flow toilets affect the CPI? Is the CPI adjusted downward because each flush uses less water and ‘helps save the environment’? Is the CPI adjusted upward because it often requires more than one flush to get the job done, or because when added to older plumbing the new toilet is prone to problems overflowing?

How about the substitution of PE for PPA, an OTC decongestant the FDA removed from the market for political not scientific reasons? Is the CPI adjusted downward because PE is politically correct and therefore represents a quality improvement or is it adjusted upward because PE is an inferior medication when compared to PPA?

Whether a quality change is positive, negative, or neutral is up to the individual consumer. When and what substitutions occur as a result of price change again is up to the consumer, based upon a host variable unique to each person.

What did you think of Cutepuppy’s post at #31?

Regarding core inflation. I don’t know enough to make a lot of comments. I do however question its appropriateness as the inflation number most frequently cited in the media and as the only inflation number used by the Fed in evaluating monetary policy. After all we need to eat and we need energy. I also have a vague memory reading that focusing on core inflation leads to monetary policies that debase the dollar, but have to look up that information could be that this is something true more recently, but not in the past 20 -30 years.

The only chart I could quickly find comparing headline to core inflation, showed both consistently trending upward. This questions the validity of rationale that headline inflation demonstrated wild swings because it included food and energy.

Focusing on the rationale for using hedonics, quality adjustments, substitution effect, and geometric weighting only draws one’s attention away form the fact that the CPI has moved from evaluating inflation in terms of a certain standard of living to evaluating inflation in terms of a declining standard living. Since the uses of the CPI (economic indicator, deflator of other economic indicator, a standard to evaluate returns on investment, a standard to evaluate COLA adjustments to wages and other payments) require an apples to apples comparison they have no place in calculating the CPI, other than to artificially depress the CPI. These tools are constantly being used over more and more categories. By now they may have extended to all of them.

I believe it was Bill Gross of Pimco who said that the Owners Rent Equivalent instituted in 1983 suppressed the CPI ~1%. I remember reading that that number increased to about 3-4% when the housing market heated up.

While flat (or declining or no) income makes inflation seem worse than 30 years ago, I believe that there are other factors involved. All the ‘interesting’ things occurring on Wall Street and in the Financial industry have lowered the value and return of savings and retirement funds. Housing values have plunged. Inflation over the last 10+ years is no longer hidden by ready access to cheap credit, and cheap goods made in third world countries by workers getting 25¢ per hour.

You and Cutepuppy look at the same information with a reasonable understanding and come to differing conclusions. I can live with that. I understand the difference in perspective.

Now a slightly different question: Considering that a housing price bottom is still nowhere in sight, doesn’t that mean that actual Wealth (Net Worth, excluding recent stock gains) is still decreasing rapidly? Isn’t a continuous reduction in Wealth the equivalent of negative earnings, offsetting stagnant actual wages? Therefore, with relatively modest actual inflation (whether Headline or Core) and declining earnings (by my definition above), don’t we have an effective inflation rate of Prices / Earnings that is substantially higher than either Core or Headline CPI report?

I think the negative wealth effect of housing is killing families’ ability and willingness to spend their fewer and fewer asset / earnings dollars on the somewhat more expensive stuff of life.

That would perfectly explain the difference between CPI (modest increases) and Americans’ perceptions (we’re getting poorer and hosed.)

I think the bottomless housing market price indicts the “Owners Equivalent Rent” component of the CPI as optimistic. If Owners Equivalent Rent takes into account CURRENT market prices of houses which have declined, but the average American lives in a house and pays a mortgage based on a higher acquiring price of 5 years ago, then Owners Equivalent Rent understates what actually happens to peoples’ bank accounts. Mortgage payments that are hard to walk away from remain high, while the Owners Equivalent Rent component of the CPI declines. That’s just fakery.

The adjustable component of Owners Equivalent Rent only comes to particular individuals who default on their mortgages and walk away. In that way, only the morally suspect are rewarded with the actual reduction in Owners Equivalent Rent. Upstanding citizens who honor their commitments are killed by stagnant wages, reduced house asset value, and actual CPI. I don’t see how those folks aren’t completely hosed by current circumstance, in a way that effectively creates a massive CPI for them individually.

Your thoughts, gentlemen / ladies?

Actually, the article algernonpj linked to on the use of hedonics (An inflation debate brews over intangibles at the mall - WSJ, by Timothy Aeppel, 2005 May 09) explains pretty well why asset substitution and hedonics are not only legitimate, but necessary methods of calculating price inflation lest it is overstated. Also, the controversy about hedonics was really limited to a very small percentage of CPI component which BLS decided to stop using.

Article also explains why different income groups will see and feel and, therefore, react to their personal or visible (price of food in grocery store, gas prices posted in large numbers at gas stations along the route) price inflation, and why there were suggestions of breaking index down into several different CPI rates, according to "baskets" by income, instead of BLS issuing the single "average" CPI.

That's also the conclusion from the article I linked before:

These days, inflation is much lower. Yet to many Americans, it feels worse now. And for a good reason: Their income has been even flatter than inflation.
Back in the '80's, the money people made typically more than made up for high inflation. In 1981, banks would pay nearly 16 percent on a six-month CD. And workers typically got pay raises to match their higher living costs. No more.

Much more relevant adjustment that has been made in the 1990s but doesn't get talked much about (maybe because it seriously overstated previous CPI) was change from arithmetic / compounded rates to geometric rates. (See Inflation, Hedonics, and How Silicon Valley May Have Wrecked Our Monetary Policy - Adam Nash, 2008 February 27)

The Bloomberg's Chart #3 that shows the difference between Core CPI and non-Core CPI is interesting in a couple of respects:
1. What sense would it make for BLS to understate Core CPI while at the same time showing "normal" non-Core CPI (which includes food and energy) - wouldn't they think that the difference would explode exponentially over time and lose their relative correlation over long period of time?

2. (Partially, an answer to 1.) The Bloomberg chart is only from the small period of early 2005 (during sharp housing and energy inflation) to the early 2008, just before the period of sharp housing and energy deflation. At that period, it's quite possible that non-Core CPI would dive faster and harder than Core CPI.

Here is a Bloomberg's chart for a Euro-Zone price inflation over period from 2005 to March of 2011, where you can see the "Big Swoon" from 2008 to 2010 (chart is "normalized" for annual rates, so it's easier to see):

EUECON

Re OER (Owner Equivalent Rent):

It pays to take note that housing comprises about 30% of CPI, and that the disparity between the price of "similar" house is huge and varies greatly depending on state, city and other geography - "Location, Location and Location". Good luck measuring "average" house price, and the "equivalent" cost to the people who do not own one. It seems reasonable to "normalize" owners and renters with a common metric for the purposes of "average" index. OER is basically a first derivative of house ownership.

And while the housing prices were bubbling up dramatically in some geosectors of the country, the rents didn't (sometimes due to rent controls, sometimes due to market forces). That means that the usual metrics of the house pricing (Price to numbers of years of gross/net annual rent income, or PS/PE equivalent for equities) were getting seriously out of whack, i.e. people were paying more and more for the houses with the essentially same rent / OER.

Following articles explain the relationship between prices and rent or PS/PE, in different locales:
Housing Trends | America's Most Overpriced Real Estate Markets - Forbes, by Matt Woolsey, 2007 May 04
Housing Trends | Most Affordable U.S. Real Estate Markets - Forbes, by Matt Woolsey, 2007 August 02
Housing Trends | Least Affordable U.S. Real Estate Markets - Forbes, by Matt Woolsey, 2007 August 23

While BLS calculates the housing and OER in terms of "cost," the owners of property usually consider it "wealth." Of course, the ownership "wealth effect" obscured that fact, and the "flippers" didn't care about PS/PE ratios in the first place, during the bubble. Now the "wealth effect" is negative, but the rents generally are not coming down in price nearly as fast as the price of the house, so OER can smooth the inflation/deflation line (similarly to Core CPI) relative to more volatile (at least in recent years) real estate prices.

Basically, for the owners, the "wealth effect" obscured the relationship to rent prices (and their "natural" relationship to the price of the house) just as now the negative "wealth effect" obscures the fact that the rent prices have changed mostly with the "rate of inflation," or relatively little over last 5-8 years, while the ratios of property prices to rent had wide swings.

It makes sense that the people who think that CPI is understating the visible food and energy price inflation, would think that BLS also understates the decline in housing prices in some geographical areas that are visible signs of burst bubble (e.g., AZ, CA, FL, NV, NY) BLS is trying to measure the change in cost of "rent equivalent" or rent, not the change in wealth.

What we feel as overall price / cost increases or decreases is very subjective depending on our "reality" and our own "basket" of goods and services, and its relationship to our income and spending habits (our "weighting") - it very seldom resembles the "average" (which in itself is difficult enough to measure).

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