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Imputed Rents and the ECB

By Julius Probst

I recently had a very interesting conversation with Christian Kopf from Union Investment who subscribes to our services. We discussed monetary policy and the ECB’s intention to include imputed rents into inflation measures. When it comes to this question, Mr Kopf and myself are in full agreement.

So what is it that I concluded, you might ask? 

Read on to find out. 

Why are imputed rents included in GDP?

For those that are a little rusty on the exact definition of imputed rents, a quick recap: Imputed rent is the estimated rent that a homeowner would pay to himself.

In a recent blog post, I discussed the impact of imputed rents on our perception of GDP. As house prices have risen quite substantially in recent decades, so have imputed rents, with the unintended side-effect of pushing down the gross labor share.

The reason why imputed rents are included in GDP calculations is to make these figures more comparable across countries. Imagine two economies, A and B, that are precisely the same with one exception: In economy A I live in my house and you live in your house. In economy B, on the other hand, I live in your house for some reason and pay rent to you whereas you live in my house and pay rent to me.

All things being equal, economy B would be larger simply because we pay rent to each other even though its economy is not more productive. Economies with lower home ownership rates, such as Germany, would therefore have an “inflated” GDP figure. If we include imputed rents, on the other hand, then the two economies have the same GDP figures again, which makes sense, given that they also have the same productive capacity.

Imputed rents are on the rise in Europe…

I fully agree that imputed rent is a type of factorless income that should be included in the calculation of Gross Domestic Product. However, including imputed rents into inflation figures is another matter entirely, and, in my opinion, makes no sense at all!  

If my house in which I live increases in value, imputed rents increase likewise. I am wealthier than before, but in no way has my cost of living increased, or anybody else’s.

As one can see from below, imputed rents have increased as a share of GDP in recent years in most European countries.

… but not in the UK 

One exception seems to be the UK economy, where imputed rents have actually declined. It looks like the ONS overhauled their methodology a couple of years ago, which led to the following imputed rent series.

This is in stark contrast to the US figures, for example, which have been on an upward trend in recent decades. Obviously, the most recent surge is due to the Corona shock with the denominator – GDP – plunging.

Unfortunately, I do not have a good explanation as to why imputed rents have fallen in the UK, yet. 

Maybe it is related to declining house prices post 2008? Moreover, home ownership rates have fallen from above 70% to about 65% over the last two decades, which should also affect total imputed rents.

I am happy to discuss an alternative explanation if you have one… just drop me a comment below.

Does it matter that actual rents are underweighted in the Euro Area?

Obviously, actual rents are also correlated with rising house prices, but actual rents are part of the HICP index and therefore are included in official inflation figures.

There is a separate discussion that actual rents are underweighted in the inflation basket. This might very well be true, but should have no bearing on the argument of whether imputed rents should be included in inflation figures or not.

As you can see , the weight for rents is just a little over 6% in the Euro Area HICP, which strikes me as very low, given that many people have to spend a substantial share of their income on rents.

In the US, on the other hand, imputed rents are included in the CPI with a weight of more than 24% as of late (they have a lower weight in the PCE index).

Case in point: USA

The corollary of what I have written above, is of course, that we should exclude imputed rents from the US inflation figures, which is exactly what I will do in a moment.

The next graph shows the year-on-year change in the CPI as well as the year on year change in imputed rents. The weight that imputed rents have in the CPI index has also slightly increased in recent decades.

In the graph below, I have displayed the CPI inflation as well as an inflation rate where the imputed rents are excluded from the overall series.

As one can see, my calculation leads to an adjusted inflation rate that is on average roughly half a percentage point lower. Imputed rents therefore lead to a quite significant upward bias in inflation figures.

Is monetary policy in the US even more contractionary than we thought?

In the next graph I have displayed the actual price level as well as a hypothetical price level where imputed rent inflation is included. As one can see, my adjusted series is about 20 points lower in 2016, starting from an index level of 162 in 1998. This also implies that the Fed has undershot its inflation target by even more than what is commonly assumed.

The obvious conclusion is that monetary policy was even more contractionary than Market Monetarists have claimed in recent years, given the upward bias in inflation figures.

To sum up, in my opinion, imputed rents should not be included in measures of inflation since they do not affect anybody’s cost of living and do not represent actual income streams. Imputed rents are directly derived from asset prices, which also should not be included. There is a good reason to believe that actual rents are currently underweighted in inflation measures, but this is a very different problem that can be addressed. The solution to this problem cannot be to include something into the CPI that should not be there.

So, to answer the question of whether the ECB should include imputed rents simply because it would artificially lead to a higher inflation rate and get the ECB closer to target, No, this is not the way to go.  Instead of playing statistical games, pursue a more expansionary policy to achieve your target!

It is as simple as that.

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