“…shelter costs, a third of the CPI. Think about the chicken and the egg. If if the Fed lowers rates, you wind up having lower mortgage rates. You wind up having lower CPI, right. So for me, they’re enforcing that higher CPI by not cutting rates. So if you could cut rates a third of CPI comes down, a third of CPI comes down….Used car prices. Why aren’t used car prices moving down? Interest rates. So you have mortgage rates, interest rates for used car prices. Everything that the Fed is doing is fostering higher prices”.

Almost as surprising was that no one challenged this flawed understanding except to object to the use of the transitive rule (if A = B and B = C then A = C). Even CNBC’s famous bond expert Rick Santelli joined the discussion and failed to correct these assertions. (Fortunately, he agrees that inflation is a problem for the Federal Reserve). I am guessing these assertions were not ad hoc and came from somewhere that others consider to be an authoritative source, so I feel compelled to offer a correction.

First of all, the U.S. Bureau of Labor and Statistics (BLS) started phasing out financing costs from the CPI in the early 1980s. At the time, the Fed was fighting inflation with aggressive rate hikes and the inclusion of financing costs in the CPI made it hard to explain monetary policy. Thus, the current definitions of items in the CPI exclude financing costs both implicitly and explicitly. The BLS describes the inclusions and exclusions for the CPI in “Consumer Price: Concepts” where it explains that “interest costs and finance charges are…out-of-scope”.

Financing Costs Are Not Consumption Goods

Shelter costs are not based on the price of a home or its financing. Instead, the BLS uses Owner’s Equivalent Rent (OER) which is the amount a household would have to pay to rent their home.

“Using the sample of rental units, the CPI program calculates a measure of price change for each CPI index area for the rent and OER indexes. The first step is standardizing the collected rents so that all rents are on a monthly basis. These standardized rents are called normalized rents. The normalized rents are then adjusted for any quality changes such as an additional bedroom or bathroom, changes to the type of heating and cooling equipment, and changes in extra charges such as an increase in total pet fees. The CPI program also adjusts rents for the effect of aging over time. Rents are collected for the same housing units every 6 months. Consequently, each time the CPI observes the rent of a sample unit, it is 6 months older. To account for this aging, an age-bias factor is applied to the previous rent.”

There is nothing in the definition that mentions mortgage rates. The BLS considers the mortgage as part of capital and not consumption.

“Interest costs (such as mortgage interest), property taxes, real estate fees, most maintenance, and all improvement costs are part of the cost of the capital good and are also not treated as consumption items. These non-consumption costs of owned housing are out of scope for the CPI under the cost-of-living framework that guides the index.”

Similarly then, the cost to finance a car, used or new, is also the cost of the capital good and is excluded from the CPI. Here is the core of the BLS’s explanation for measuring the inflation for new vehicles:

“The new vehicles index is estimated using a transactions dataset purchased from J.D. Power that includes observed transaction-level prices and detailed vehicle information. Each observation includes a transaction price as well as a set of 40 variables including rebate values and vehicle characteristics. Sales tax rates are applied by BLS for index calculation….

The BLS also relies on prices from J.D. Power to calculate an inflation rate for used vehicles and does not include financing costs.

Hot and Sticky Inflation

While various pundits torture the data to make specific points about the insignificance or transitory nature of today’s inflation, the core CPI is actually trending higher. The upward trend confirms the bottom telegraphed by the July Beige Book.

Source: U.S. Bureau of Economic Analysis, Personal Consumption Expenditures Excluding Food and Energy (Chain-Type Price Index) [PCEPILFE], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/PCEPILFE; U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: All Items Less Food and Energy in U.S. City Average [CPILFESL], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/CPILFESL, September 11, 2025.

From my perch, I still see all systems go for hot and sticky inflation. I see only additional inflationary pressures from rate cuts. Turkey learned this lesson, and much of the Federal Reserve acknowledges (or used to acknowledge?) the inflation risks. But we are officially climbing the stairs of hopeful monetary policy…hoping that the rate cuts can heal the employment market faster than it can stoke higher inflation.

Be careful out there!

Full disclosure: no positions

The post Financing Costs Do Not Impact Calculated Inflation appeared first on Inflation Watch.

Tim Iacono wrote back in 2007: “OER is one of the poorest proxies the world has ever seen as demonstrated by the comparison below with the Case Shiller Home Price Index.”

Source: Tim Iacono

Andrew Jeffrey made a similar point earlier this year:

The statistical alchemists, err, experts, at the Bureau of Labor Statistics use something called “owners equivalent rent,” OER, to measure consumer housing expenses. OER tries to approximate the cost to rent the country’s typical home, and according to the Wall Street Journal makes up 24% of the CPI and 31% of the core CPI, which backs out food and energy costs.

And since even as property values have slid in record-breaking fashion rents remained buoyant, OER has vastly understated the drop in home prices. This means the CPI–were it to reflect some sort of economic reality–would have fallen more than it actually has.

Of course, times change.  Although home prices are still well below their peak, and some observers continue to talk of an ongoing crash in home prices,  the housing market has been on the mend since the spring of 2009–at least if you believe the S&P/Case-Shiller Home Price Index. As was the case in 2007-08, there is a discrepancy between the Case-Shiller index and the owners’ equivalent rent component of CPI, but this time the mismatch causes inflation to be under-reported rather than over-reported.

Let’s look at the numbers. Between April 2009 and August 2009 (the latest month available for the Case-Shiller index), the Case-Shiller index rose from 139.2 to 146.0–an increase of 4.9 percent. By comparison, the owners’ equivalent rent component of the CPI rose from 256.6 to 257.2 during the same period–an increase of just 0.2 percent.  In other words, the rate of home price inflation was nearly 25 times higher than that shown by the CPI.

The CPI as a whole increased from 213.2 to 215.8 — a rise of just 0.1 percent. But if we replace owners’ equivalent rent with the Case Shiller index, CPI would have increased 2.4 percent during this four-month period–an annualized rate of 7 percent.

For simplicity, these calculations are based on seasonally-unadjusted numbers. The results might be slightly different if they were based on seasonally-adjusted figures, but the basic point would not change, i.e.,  reported inflation since April 2009 would be much higher if not for the CPI’s use of owners’ equivalent rent.

Admittedly, the picture is very different if one looks at year-over-year inflation. The Case-Shiller index declined 11.3 percent between August 2008 and August 2009, whereas owners’ equivalent rent increased 1.7 percent. So CPI significantly overstates year-over-year housing inflation. This  overstatement will  gradually get smaller before disappearing entirely in mid-2010, unless housing prices begin to fall again. (Recent reports indicate that housing prices are continuing to rise.)

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