Clues to ECB’s Inflation Dilemma Could Lie Very Close to Home

(Bloomberg) — When Christine Lagarde tries to work out why the European Central Bank can’t hit its inflation goal, she might need to look at the measure itself.

The institution’s new president, who is widely expected to start a strategy review, is attempting to hit an official gauge of consumer-price growth that grossly under-represents housing costs by only including residential rents. That ignores the 66% of homes that are owner-occupied.

Economists say that by overlooking one of consumers’ biggest expenses, the ECB effectively traps itself into pumping ever more monetary stimulus into the financial system. A striking metric is that Eurostat, the European Union’s statistics agency, assumes people spend about just 6.5% of their after-tax pay on shelter.

“This of course is a ridiculous figure, when the average earner is spending around 30% of his salary on rent,” economist Daniel Gros, director of the Centre for European Policy Studies think tank in Brussels, said in an interview. There is a “fundamental problem” in a gauge whose components are “so divorced from private-market data.”

Lagarde started as ECB president this week, and has hinted that one of her first moves could be an internal review of why the institution has fallen far short of its inflation goal of “below, but close to, 2%” for years. That would be the first strategic overhaul since 2003, and could be an important — not to mention politically popular — step on the path to escaping negative interest rates and massive bond purchases.

“Economic relationships and trends shift,” she said last month at a farewell event for her predecessor, Mario Draghi. “Policy reactions that were appropriate two decades ago are no longer valid.”

Rent Caps

Eurostat arrives at such a low figure for housing because its calculation — drawn from national datasets — is skewed. It includes rent, which is defined as a consumer service, but not the much larger mortgage repayments for home purchases, which are considered an investment.

Moreover, millions of rent increases are capped by local laws at inflation, creating a feedback loop. New rental contracts can mask big hikes, and newly built properties with market-level rents are often overlooked.

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

Other economies have developed inflation measures that better capture the costs of being an owner-occupier. The U.S. Bureau of Labor Statistics weights housing at more than 30% in its consumer-price index.

The U.K.’s statistics office said in 2017 that its lead measure of inflation would include the costs of owning, maintaining and living in one’s own home, which is currently weighted at about 23% of the basket. It’s published alongside the older gauge by which the Bank of England judges its mandate, though BOE Governor Mark Carney has said it would be “highly desirable” to have a single reference.

Near to Goal

Both nations have tended to have stronger inflation, and both avoided negative interest rates. While that’s also due to other factors such as lower unemployment and stronger fiscal support, Gros says the euro zone would also have seen an impact if it had adopted a broader measure.

The ECB would “have reached, or be very close to reaching” its inflation goal, he said in a report for the European Parliament in 2018.

Sylvain Broyer, an economist at S&P Global Ratings, said last month that including owner-occupied housing would have added 0.3 percentage point to measured price growth in the euro zone, and may have made the latest round of quantitative easing unnecessary.

Frederik Ducrozet, an economist at Pictet & Cie in Geneva, said that adjusting the housing component “makes sense, and it’s easy to explain to the public.” That could be a selling point for Lagarde, who faces mounting concerns that the ECB’s negative rates and bond purchases are damaging financial stability.

Revisiting the inflation measure would have significant hurdles to overcome though. The ECB judged in 2016 that including owner costs “would not materially affect the inflation assessment.” Two years later the European Commission said it was “unfeasible” to assess owner costs on a monthly frequency and with the timeliness needed.

The ECB has the power to change its inflation measure. Its legal mandate is to ensure “price stability,” and policy makers settled on the current yardstick as the appropriate gauge when the central bank started operations in 1998.

In practice, officials are likely to be concerned that making an adjustment now risks complaints that they’re doing so simply because they’ve undershot the target.

“The ECB should reconsider the inflation gauge, but they won’t,” Gros predicted. “It fears being accused of changing the goalposts because it can’t score.”