Discussion of Randal Verbrugge’s:

The Puzzling Divergence of Aggregate Rents and User Costs,

1978-2001

Leonard NakamuraFederal Reserve Bank of Philadelphia*

*My views, not the Fed’s

Back to basics

• Paper points out that because interest rates and asset prices are volatile, short-term real rates of return can vary substantially from real rental rates– This is certainly true– Applies to all long term assets, not just residences

• This paper is a useful reminder of what economists don’t understand– And a valuable challenge to economists

• I am not so sure that it puts statistical agencies in a quandary: Empirically, they should use rental equivalence– Rents are understood at least somewhat– User costs are (empirically) not

Owner occupied homes:costs and equivalent rents

• Stock of housing is large, and adjusts slowly• Households adjust their use of housing slowly

– Implied real stream of housing services must change only slowly

• User costs are too volatile compared to this shadow price– Not just true for housing – user costs of capital are too

volatile (Shiller)

Implication: real quantity of housing services changes slowly

• At the margin in equilibrium, the rent summarizes the information in the user cost.– Empirical question: are rents or user costs closer to the

truth?• Good evidence that rents are reasonable:

– Hedonic estimates (Crone et al, Kurz and Hoffman)– Rents and housing prices are cointegrated: J. Gallin,

BoG, Long horizon of house prices and rents• Real rents move with real net stock of residential fixed

assets– Ratio is relatively constant over past 60 years – Particularly if we adjust BLS residential rents for

response bias (Crone et al, CPI for rents, a case of understated inflation)

Minor problems in Verbrugge measure of user costs

• To get user cost right, very hard work• Risk premiums? Shouldn’t use deterministic model• Hard to measure:

– Expected appreciation :4 quarter horizon or 40 quarter horizon? – Relevant interest rate: Mortgage rate includes refinance option

• The exercise cost has changed over time• Type of mortgage used varies over time (ARMs when rates are

high)– Cost of maintenance and repairs

• These are minor problems in the sense they are very unlikely to influence the result

• User costs too volatile to know whether trend is right

Explaining rents

• Are rents related to theoretical variables?– Another valuable question

• Rents = β(user cost)– User costs are measured with error– β likely biased downwards

• Detached units rental rates not very reliable– Too many special cases– Possibly better to use regular rental units

• Also, adjust rent inflation rates for 1978-1985 a la Crone et al

Bottom line: a valuable and difficult line of research

• This is an important issue for economics: Residential assets very large share of total wealth

• How useful are rents to measure the shadow price of owner occupied housing services?

• Why are user costs so volatile?– Why don’t house prices appear to be martingales?

• What are the returns to owner-occupied housing and are they reasonable?– Is there a equity premium puzzle for housing

• Need stochastic GE model (Luengo-Prado, Nakajima)