Housing and Monetary Policy in the Business Cycle: What do Housing Rents have to Say?

In this paper we unveil a feedback loop between monetary policy, housing tenure choice (own vs rent) and measured inflation and quantify its consequences. This feedback loop is explained in three parts: i) Housing rents respond positively to contractionary monetary policy shocks; ii) This effect of interest rates on housing rents gives rise to an important and systematic inflation mismeasurement problem because, directly and indirectly, housing rents weigh approximately 30\% in the CPI and 13\% in the PCE; iii) When interest rates are set according to a Taylor rule, the systematic mismeasurement of inflation gives rise to a feedback loop by which the monetary authority keeps setting interest rates too high (low) because inflation is apparently too high (low). To rationalize i) and quantify the importance of iii) we propose a standard New Keynesian model augmented with an endogenous housing tenure choice mechanism. Using a calibrated version of the model, we do a counterfactual exercise and estimate that, when the monetary authority targets the implied consumer price index net of housing rents instead of the implied consumer price index, the loss function of monetary policy is 14.5\% lower and the welfare in terms of consumption equivalent variation is 0.9\% higher. Finally, analyzing the same alternative scenario for the 1983-2006 US experience, we find that the standard deviation of housing prices and nominal inflation would have been 24.8\% and 19.9\% lower, respectively.