ECB to Review Inflation Gauge to Include Housing Prices

European Central Bank: European Central Bank is unable to hit its inflation goal. But Christine Lagarde has indicated that one of her first moves could be an internal review of why ECB has failed to achieve its inflation goal.

Christine Lagarde is ECB’s new president, who is expected to start a strategy review.

The move could be the first strategy overhaul since 2003 and essential because of its political popularity. It’s also a path to escaping negative interest rates and massive bond purchases.

Lagarde is attempting to hit an official gauge of consumer price growth, which adversely under-represents housing costs. The indicator includes only rents and ignores 66% of owner-occupied homes.

Economists say, overlooking one of the consumer’s biggest expenses, ECB will effectively trap itself into pumping more monitory stimulus into the financial system.

The European Union’s statistics agency-Eurostat has a striking metric that assumes people spend about 6.5% of their after-tax pay on shelter.

But, Daniel Gros- director of the Center for European Policy Studies in Brussels, thinks 6.5% is a ridiculous figure. He says an average earner spends about 30% of his salary on rent. He adds that the gauge has a fundamental problem and that its components are not in line with private-market data.

Eurostat uses skewed data from the national database causing them to arrive at such a low figure for housing. The value includes rent, which is defined as a consumer service but excludes the larger mortgage repayments, which are considered as investments.

Also, local laws cap millions of rent increases at inflation, creating a feedback loop. New rental contracts can mask hikes, and local laws often overlook newly built properties with market-level rents.

The ECB noted these flaws in the 2016 report when it concluded that housing components were “weighing down” on the inflation measure.

Economists say housing prices are the missing component in the ECB’s inflation measure

Other economists have developed inflation measures that better capture the cost of being an owner-occupier. The consumer price index by the U.S Bureau of Labor Statistics housing is more than 30%.

In 2017, the U.K’s statistics office said, their lead measure of inflation would include the cost of owning, maintaining, and living in one’s own home. The measure weighs currently at about 23% of the basket.

The Bank of England (BOE)  published the report alongside the older gauge, which the BOE judges its mandate. However, Mark Carney, the BOE governor said it would be desirable to have a single reference.

Both nations have stronger inflation and have avoided negative interest rates.

While other factors such as lower unemployment and stronger fiscal support stronger inflation, Gros says the eurozone would also have seen an impact if it had adopted a broader measure.

Gros said the ECB would have reached or been close to reaching its inflation goal. He said this in a European Parliament report in 2018.

Last month another economist, Sylvain Broyer from S$P Global Ratings said that including owner-occupied housing would add 0.3% point to price growth in the eurozone. He said that the latest round of quantitative easing was unnecessary.

Frederik Ducrozet of Pictet & Cie in Geneva said that adjusting the housing component made sense and easy to explain to the public.

The move could be a plus for Lagarde, who’s facing mounting concerns that the ECB’s negative rates and bond purchases are damaging financial stability.

However, revisiting the inflation measure would have significant hurdles to overcome. In 2016, the ECB judged that including owner costs could materially affect the inflation assessment.

Two years later, the European Commission said it was unfeasible to assess owner costs on a monthly basis within the desired timelines.

The ECB’s legal mandate is to ensure price stability, therefore able to change inflation. Policymakers settled on the current gauge as appropriate when ECB started its operations in 1998.

However, officials are likely to raise concerns that ECB is adjusting the gauge just because it undershot its target. Gros predicted.