# **3.2 Price Indexes**

The treatment of owner-occupied housing is recognized as the most difficult, complex and important (ILO, 2003, §17, 2004) sector in the compilation of consumer price indices (CPI).<sup>29</sup> Several methods could be used for measuring the value of own-occupied dwellings in a CPI. These are: the acquisition approach, the use approach (user and rental equivalence approaches), the payment approach, and the exclusion from the price index. The usefulness of the index depends mainly on how informative the index is to policy makers than on defining which one of previous methods is right.

Generally, the entire monetary expenditure paid for the acquisitions of new dwellings is optimal when the primary purpose of the CPI is monitoring macroeconomic indicators such as inflation (ILO, 2003, §131).<sup>30</sup> Inflation is in fact perceived as a monetary phenomenon in market transactions made between households and other institutional sectors. In the acquisition approach, therefore, prices are recorded at full market prices and entirely allocated to the time of purchase, in a fashion identical to the treatment of non-durables and services.

When the primary purpose of the index is to adjust compensation or income, the _Payment Approach_ could be the most appropriate (Goodhart, 2001 and ILO, 2003).<sup>31</sup> In this kind of _cash flow approach_ the consumption expenditure of owner-occupied dwelling is measured by using the out-of-pocket expenditures, e.g. initial cash outlay for the purchase of the house, mortgage repayment and interest payment, insurance, maintenance and repairs. The Payment Approach, although conceptually and computationally simple, _ignores the opportunity costs of holding the equity in the owner occupied dwelling, it ignores depreciation and it uses nominal interest rates without any offset for inflation_ (Diewert, 2013, p.49). Despite the criticisms, the Payment Approach is currently used in Austria, Chile, Ireland and the Slovak Republic (Table 1).

The _use_ cost of the services for owner-occupied dwelling during certain period is correct when taking the standard-of-living approach to the CPI (Diewert, 2013, ILO, 2004, ch 23).<sup>32</sup> The _Use Approach_ comprises the rental equivalence and the capital market approach. The _Rental Equivalence Approach_ evaluates the owner-occupied dwellings with the actual rents paid for similar properties by tenants when the rental market exists. There are different ways to implement this approach; for instance by asking owners about the potential rent of their dwellings;<sup>33</sup> or housing experts (ILO, 2003); or by applying statistical or econometric techniques.

According to the _Capital Market Approach_ , the value of an owner occupied dwelling is based on the current market value of the dwelling adjusted for the opportunity cost of the equity, the depreciation rate, property taxes and insurance, and the cost of maintenance and repairs (ILO, 2003, 2004, Diewert, 2013). There are two options: the rent-to-value approach (US Bureau of Economic Analysis) and the user-cost approach (see ILO, 2004; Diewert, 2013; Guðnason and Jónsdóttir, 2009 for the Iceland example).

Exclusion of the price of housing from the CPI is justified on the basis that house ownership is assimilated to a capital asset (see ILO, 2004). The Euro-Area Harmonized Index of Consumer Prices, for instance, excludes to date any treatment of owner-occupied housing, although Eurostat admits that this

> 29 Indices that reflect the change in prices paid by a representative household for a representative basket of goods and services.

> 30 Even within the framework of measuring inflation, there is some debate on the appropriateness of including housing for monetary policy purposes, mainly for the risk of including volatile assets which would in turn lead to unstable price indices (see Goodhart, 2001). 31 Originally, this was the CPI’s purpose.

> 32 The aim of the index is to measure changes in the cost of living.

> 33 This is the case of the US Bureau of Labor Statistics.

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