Inflation indices do not reflect reality

The argument

The claim that inflation is understated is made here through a specific measurement decision: how the official price index handles housing. Since 1983 the government has measured the price of homes not by looking at house prices but by computing what it calls Owner's Equivalent Rent — the rental value of a house. The choice is not a technicality at the margin of the index. OER accounts for nearly a quarter of the entire Consumer Price Index, which gives it a correspondingly large influence on the headline inflation figure. The difficulty is that the substitute does not track the thing it stands in for. When the change was made, the inflation rate diverged sharply from changes in house prices. OER remained fairly subdued while house prices surged in the period before the housing bust, and afterwards the reverse happened. The two measures diverged, so a quarter of the index was being driven by something other than what households were actually paying to buy a home. The consequence was a policy failure. If the Federal Reserve had been looking at house prices, it would have tightened monetary policy in response to house-price inflation. Instead it relied on OER, which understated inflation — so the measure did not merely describe the economy inaccurately but shaped the decisions taken about it, leaving rising housing costs unaddressed because the official figure did not register them. What the episode shows is that an index is only as good as the proxies it is built from. The mechanisms the government uses to estimate inflation are not reflective of the reality of prices, and because a substitute that diverges from what it replaces carries so much weight in the index, inflation is understated.

Premises

Counter-arguments

Critics argue that using Owners' Equivalent Rent is a defensible choice, not a distortion. A consumer price index is meant to measure the cost of consuming shelter services, and a house price mixes that consumption with an investment asset — buying a home is partly buying an appreciating asset, not just paying for a place to live. Pricing shelter by rents deliberately strips out the asset-bubble component, so OER staying subdued while house prices surged is arguably the index working as intended rather than failing. They add that the argument rests on a single component and a single episode. Pointing to the pre-2008 divergence in one large category does not show the overall index systematically understates inflation, since other components can offset it and the rival 'inflation is overstated' position marshals the opposite case (quality adjustments, substitution). On this view OER is a methodological judgement economists debate, and one contested episode does not establish that inflation is understated overall.

Rejecting the premises

[Rejecting P1] Critics argue OER is a deliberate, defensible method: a cost-of-living index should measure shelter as consumption, and house prices conflate that with investment value, so pricing by rents is not a failure to reflect reality. [Rejecting P3] The pre-2008 divergence is one component in one period; it does not show the whole index systematically understates inflation, especially as others argue CPI overstates it, so the conclusion overreaches from a single case.