HOUSE PRICES IN THE MEASUREMENT OF INFLATION IN THE EURO AREA

I. INTRODUCTION While widespread agreement has emerged in recent years that price stability should constitute the primary goal of monetary policy, many issues surrounding how best to measure aggregate price movements remain unresolved. Some of these issues relate to the broad concept of what it is the monetary authority should be trying to measure while others have a more practical orientation, focusing on whether and how to include certain constituent price series in aggregate measures and how best to deal with short-run volatility. Of course, to a large extent, these issues are interrelated with one another. One of the key topics under discussion in Europe is whether and how to include costs associated with owner-occupied housing (OOH) in the harmonized index of consumer prices (HICP). In the run-up to European Economic and Monetary Union (EMU), a myriad of challenges faced policymakers and statisticians from member countries, not least of which was the task of defining and implementing a common measure of inflation across the countries planning to participate in EMU. Prior to EMU, significant differences existed in the methodologies used to construct national price indices, and in this context, a decision was made to exclude OOH from the HICP. From all appearances, this decision was made in large part for practical reasons. Eurostat has identified the issue of how to deal with OOH as one of the most important issues remaining in the design of the HICP. The issue is under active discussion, and a decision is expected, according to the European Central Bank (ECB), (1) by 2008. If the costs associated with OOH are to be included in the HICP, two key decisions need to be made. The first is to decide on how to measure these costs. Section II summarizes some of the arguments for and against the inclusion of OOH and outlines alternative measures that have been identified. The other decision relates to the weight these costs should receive relative to the other components of the index. Policy discussions have suggested possible weights as high as 20%, which could obviously alter significantly the pattern of measured inflation. This is of particular concern in the euro area as the ECB has a numerical target for the HICP. (2) Section III discusses an alternative weighting scheme to the current expenditure-based approach where the constituent series are weighted on the basis of their statistical properties. This approach represents a profound departure from the expenditure-weighted scheme adopted by Eurostat to reflect the ECB's mandate to preserve the purchasing power of money. Therefore, it should not be thought of as an alternative for measuring the ECB's numerical target but rather as a potentially useful indicator of core inflationary pressures in the euro area. Section III includes a discussion of the origins of this statistical approach and its potential suitability as an indicator for the ECB. Section IV presents the results using weights from this signal extraction approach and compares the historical inflation series produced from the different weighting schemes. The policy implications of using an inflation target that includes OOH are explored in Section V, while Section VI concludes. The hypothesis tested in this paper is that the choice of weighting scheme will be crucial in determining the impact of the inclusion of OOH in the HICP. This choice depends ultimately on the theoretical underpinnings of the inflation measure. Statements by Eurostat about the nature of the HICP have opened the door for alternative weighting schemes to the traditional expenditure-based approach. This study illustrates the outcome of employing one particular signal extraction approach to the weighting question, showing that the inclusion of house prices in this way does not significantly impact the measured inflation rate. II. THE TREATMENT OF OOH The costs associated with OOH pose particular difficulties in the compilation of an index of consumer prices. …