Statistics Canada is being urged to change the way it calculates housing costs in its inflation reports, with critics saying its current method could be fuelling a housing bubble.

In a report released Wednesday, the C.D. Howe Institute, one of Canada's leading policy think-tanks, argues that house prices have risen far faster than has been captured by Statistics Canada in the past few years.

If a true measure of house price increases is used, inflation would have been close to a percentage point higher in most years since 2009, when home prices began taking off, likely causing the Bank of Canada to hike interest rates, the report argues.

The problem, says Philippe Bergevin, a senior policy analyst with the institute, is that the statistical agency calculates changes in the costs associated with owning a home, not the actual changes in the prices of homes sold.

Owner-occupied housing costs incorporate mortgage payments, which have been mostly flat since 2009 due to the Bank of Canada's low interest rate policy as home prices have been climbing, so the net effect is to miss the house price acceleration.

"I think some people might be surprised to learn that the housing component of the CPI (consumer price index) has actually been pulling down the inflation rate in the last few years," he said.

"If you look at the housing component right now, it has stayed pretty much flat at the same time as house prices have been going up."

Prices outpace ownership costs

By some estimates, home prices in Canada have risen more than seven per cent in some years since the recession.

Bergevin is not asking Statistics Canada to drop its current method, which he said is useful in measuring cost of living. But he said the agency should add a new index, as it does with core inflation, that paints a truer picture of house price fluctuations.

Australia and New Zealand currently uses the approach he is advocating, and European countries are also introducing new house price indexes, Bergevin said.

Statistics Canada did not immediately respond to a request for comment.

The agency has been asked to tweak the way it calculates inflation in the past, particularly over its failure to capture the ability of consumers to substitute higher cost items for lower cost ones. According to some economists, the bias can over-report inflation by as much as 0.6 percentage points.

But in the current period, and in the decade before the recession, Bergevin's calculation is that the bias has been to underestimate the true inflation rate.

The gap is not insignificant or academic, the paper argues, since central bankers adjust monetary policy — particularly the setting of interest rates — largely on inflationary expectations.

Low rates make problem worse

With inflation muted, Bank of Canada governor Mark Carney has kept the bank's trendsetting policy rate unchanged at one per cent the past two years, and many expect it will remain at the current level until well into 2013.

The Bank of Canada routinely refers to inflationary pressures, or lack of, in its monetary policy announcements to explain why it is adjusting interest rates or leaving them unchanged.

Low interest rate policy for extended periods is what got the world in a mess in the first place, Bergevin points out.

Using the U.S. example, the paper says that real estate prices rose about three times higher than was reflected in the country's inflation data during the 2000s prior to the 2008 crisis, allowing the Federal Reserve room to keep interest rates at rock-bottom levels and helping to create a housing bubble and subsequent bust.

The same thing may be happening in Canada, Bergevin said, although it is difficult to pin-point exactly how the secretive Bank of Canada policy panel arrives at its decisions, and how much weight it gives to the posted inflation rate. The paper notes that the central bank has a wide array of in-house information on housing.

"But yes, a one per cent difference in inflation should, other things being equal, make the bank perhaps raise interest rates higher and sooner," he said.

At the very least, he said the bank would find it more difficult to explain its actions if they could not be directly linked to the CPI, given that its mandate is to keep inflation in check.

Canada's inflation rate is currently 1.3 per cent, but hit as high as 3.7 per cent in May of 2011.