September 12, 2012 – The Bank of Canada needs a better inflation indicator that is more sensitive to swings in house prices than the Consumer Price Index (CPI), according to a new report from the C.D. Howe Institute. In “Housing Bubbles and the Consumer Price Index: A Proposal for a Better Inflation Indicator,” Philippe Bergevin points out the CPI has not usefully reflected the rapid run-up in housing prices in recent years. He proposes a new official inflation indicator for monetary policy purposes that would better reflect the prices of houses sold in the market.
“The use of assumed prices for dwellings rather than actual prices for houses and the inclusion of a mortgage interest component make the CPI less sensitive than otherwise to housing price changes,” notes Bergevin. The main concern, he adds, is that the CPI’s insensitivity to housing could potentially cause the central bank – reassured by its imperfect indicator that inflation is under control – to keep rates too low for too long.
Of course, the Bank of Canada has access to a wide array of data that provide information on the housing market. Yet it is hard for a central bank to tune or communicate monetary policy if its actions cannot easily be linked to its inflation-targeting mandate.
Bergevin recommends that Statistics Canada construct and maintain, in addition to the current CPI, an inflation indicator that treats housing like other consumption goods and is based on a net-purchases approach for owner-occupied housing. This approach measures changes in market prices – transaction prices – for owned accommodation; it treats the purchase of a house exactly like any other purchase and doesn’t consider how the purchase is financed, meaning it does not include an element relating to interest rates. “As currently measured, the housing component of the CPI drops when interest rates fall, which sends the wrong signal about inflation since lower rates support higher than otherwise housing prices,” notes Bergevin.
The report further recommends that, should this inflation indicator be established, the Bank of Canada monitor it on a continuing basis and consider it when setting policy rates. Over time, the Bank of Canada may even consider adopting the proposed measure as its official inflation indicator.
Click here for the full report.
For more information contact: Philippe Bergevin, Senior Policy Analyst, C.D. Howe Institute, 416-865-1904; email: cdhowe@cdhowe.org