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  1. #1

    Default The Truth about CPI

    An Inflation Debate Brews Over Intangibles at the Mall;
    Critics Say U.S. Plays Down CPI Through Adjustments For Quality, Not Just Price; Value of a TV's Flat Screen

    WASHINGTON -- To most people, when the price of a 27-inch television
    set remains $329.99 from one month to the next, the price hasn't

    But not to Tim LaFleur. He's a commodity specialist for televisions
    at the Bureau of Labor Statistics, the government agency that
    assembles the Consumer Price Index. In this case, which landed on his
    desk last December, he decided the newer set had important
    improvements, including a better screen. After running the changes
    through a complex government computer model, he determined that the
    improvement in the screen was valued at more than $135. Factoring
    that in, he concluded the price of the TV had actually fallen 29

    Mr. LaFleur was applying the principles of hedonics, an arcane
    statistical technique that's become a flashpoint in a debate over how
    the U.S. government measures inflation.

    Hedonics is essentially a way of accounting for the changing quality
    of products when calculating price movements. That's vital in the
    dynamic U.S. economy, marked by rapid technological advances. Without
    hedonics, the effect of consumers getting more for their money
    wouldn't get fully reflected in inflation numbers.

    But even as the Federal Reserve raises interest rates amid a recent
    uptick in inflation, many critics complain the hedonic method is
    distorting the picture of what's going on in the economy. They say
    hedonics is too subjective and fear it helps keep inflation figures
    artificially low -- meaning the Fed may already be lagging in its
    inflation-fighting mission.

    It's critically important for consumers, business, the governmen,t
    and the economy as a whole that the CPI is as accurate as possible.
    The CPI is used to benchmark how much is paid to Social Security
    recipients, who last year received outlays of $487 billion. It also
    plays a role in adjusting lease payments, wages in union contracts,
    food-stamp benefits, alimony and tax brackets.

    Getting the CPI right is immensely complex and can seem
    counterintuitive. Consumers sometimes have the impression that the
    government must be missing something -- since inflation has remained
    remarkably low in recent years, even as housing prices, medical
    bills, and other daily costs have soared. Hedonics helps explain part
    of the difference.

    There are also differences in the mix of things people buy. For
    instance, healthy people spend far less on health care, an area that
    has seen particularly strong inflation. And not everyone pays college
    tuition, another area where prices have been marching rapidly higher.

    The issue is likely to gain more attention now as signs of
    inflationary pressures grow. Consumer prices jumped 0.6% last month,
    the biggest increase in five months, as the prices of energy,
    clothing and airline fares all rose sharply. On an annual basis,
    consumer prices rose at a 4.3% rate in the first three months of this
    year, compared with 3.3% for all of last year.

    Bill Gross, head of the world's largest bond fund, Pimco, caused a
    stir last fall by proclaiming that the way the CPI is calculated
    amounts to a "con job" by the government aimed at concealing the true
    rate of inflation. A key culprit, he said, was the CPI's growing
    reliance on hedonics. Mr. Gross, who has other complaints about how
    inflation is tracked, estimates the CPI really is one percentage
    point higher than official figures suggest.

    That's important for bond investors, who view inflation as their
    biggest enemy. Bond holders receive a fixed interest payment on their
    bonds that is eaten away by inflation. If there is hidden inflation
    in the economy, bonds are less valuable.

    Likewise, Andrew Harless, vice president of econometric analysis at
    Atlantic Asset Management in Stamford, Conn., takes issue with
    hedonics. "Price decline and quality improvement are not the same
    thing," he says. As a result, any index that treats it as such is
    likely to be misleading.

    Inflation watchers at the statistics bureau say critics exaggerate
    the significance of hedonics, noting that it's used in only seven out
    of 211 product categories in the CPI. In most of those, officials
    say, hedonics actually magnifies price increases rather than
    suppressing them.

    Take housing, which makes up about 30% of the CPI. Critics often
    blast the CPI for using a measure based on what it costs to rent
    homes rather than what it costs to buy them -- thereby avoiding the
    recent run-up in housing prices. The bureau says it is more concerned
    with monthly costs of housing than the long-term value of houses, so
    it thinks rents are a better gauge.

    The bureau says hedonics actually helps boost the housing component
    of CPI. In order to take into account the aging of housing, and
    presumably falling quality that goes with it, the CPI applies a form
    of hedonics that links the age of a housing unit to rents. If someone
    is paying the equivalent of $500 a month in rent for several years,
    the rent has actually gone up as the unit ages and becomes less
    desirable, according to the government.

    Hedonics, which literally means the "doctrine of pleasure," was a
    term first adopted by a General Motors economist, Andrew Court, who
    studied auto prices in the 1930s. He had created a method of linking
    car prices over time to features such as weight and horsepower, and
    wanted a name for the statistical method that emphasized the link
    between features and consumer utility.

    The technique stirred few passions until the technology boom of the
    1990s. By then, government agencies had realized they needed a better
    way to track quality changes in computers and other fast-changing
    high-tech goods.

    Federal Reserve Chairman Alan Greenspan, testifying before the Senate
    Finance Committee in 1995, said that he thought the CPI was biased
    upward by as much as 1.5 percentage points. The political response
    was immediate: If inflation was lower than supposed, it would be
    possible to rein in deficits without cutting spending or raising
    taxes. That's because the lower inflation rate would translate into
    smaller payments to Social Security recipients and other big-ticket
    items for the government.

    Shortly thereafter Congress established the Advisory Commission to
    Study the Consumer Price Index, better known as the Boskin
    Commission. The panel confirmed Mr. Greenspan's view and said about
    half the bias was due to product innovations, such as those seen in
    computers, which were being overlooked in the CPI. Thus began a push
    to apply hedonic techniques more broadly.

    Today, the hub of this effort is a warren of beige-walled cubicles at
    the Bureau of Labor Statistics a few blocks from the Capitol. Here 40
    commodity specialists hunch over reports with 85,000 price quotes
    that flow in from around the country every month. The numbers are
    gathered by 400 part-time data collectors. They visit stores and note
    prices on the items that make up the basket of goods in the CPI,
    ranging from ladies' shoes to skim milk to microwave ovens.

    One of the biggest challenges in this process is finding substitutes
    for products that disappear from store shelves or change so much that
    they are hard to recognize from one month to the next. With TVs, for
    instance, data collectors find the models they priced the previous
    month missing about 19% of the time over the course of a year.

    When that happens, the data gatherer goes through a four-page
    checklist of features such as screen size and the type of remote
    control to find the nearest comparable model. Once this process
    identifies a product that appears to be the closest match, the data
    gatherer notes its price. The commodity specialists back in
    Washington check over these choices and decide whether to accept them.

    Mr. Harless at Atlantic Asset Management says all these judgment
    calls add up to a process that is far too subjective. The CPI "takes
    something you can't really measure and applies a metric to it in ways
    that are arbitrary," he says. "There ought to be some kind of warning
    label on inflation numbers that are derived from hedonic pricing."

    David Johnson, the economist who heads the CPI program at the bureau,
    says, "There's no doubt the analyst has to make decisions about
    what's comparable and what's not, and where adjustments should be
    made, but we try to use the data from all the markets to make that

    Many price adjustments in the CPI are straightforward: When candy
    bars get smaller, but are sold for the same price, the CPI reflects
    that as a price increase.

    Todd Reese, the commodity specialist for autos, says he doesn't need
    hedonics to extrapolate the value of quality changes, because auto
    makers present him with a list of changes to the car and the
    corresponding prices. Still, Mr. Reese must make some tough calls as
    he does his job. For instance, he recently considered a 2005 model in
    which the sticker price went from $17,890 to $18,490. The
    manufacturer cited an extra cost of $230 to make antilock brakes
    standard, while it said it saved $5 by dropping the cassette portion
    of the CD player.

    The bureau accepted both those items, so the ostensible price
    increase shrank by $225.

    But the car maker also told Mr. Reese it wanted to subtract $30 from
    the price increase for the cost of putting audio controls on the
    steering wheel, allowing drivers to change channels without reaching
    for the radio dial. "We didn't allow that claim," says Mr. Reese. "We
    didn't judge that to be a functional change."

    The most visible and controversial application of hedonics in the CPI
    has been in computers, where hedonics sharply accelerated price
    declines starting in the late 1990s. Recently, the bureau has quietly
    stopped using hedonics in computers.

    Mr. Johnson, the CPI economist, says the change, which took effect in
    September 2003, was mainly driven by "timeliness" issues. With
    computers changing so rapidly, the agency found it difficult to keep
    its hedonic models up-to-date. At the same time, he says, the
    components of home computers have increasingly become commodities,
    making it far easier to price the various parts separately, such as
    memory or screen size, by going straight to manufacturer sources that
    list those prices.

    The decision to stop using hedonics on computers in the CPI, which
    hasn't been publicized, came in the wake of a 2002 report by the
    National Science Foundation's Committee on National Statistics. The
    report concluded that hedonics may be one of the most promising ways
    of dealing with quality changes, but the agency should be more
    cautious in adopting it.

    "The controversy is really about a small category of electronic
    goods," says the CPI's Mr. Johnson. Rapid quality advances in
    everything from DVD players to microwave ovens means that hedonics
    does, in fact, have the effect of pushing down that part of the
    index, he says. However, electronics accounts for less than 1% of the
    overall index.

    Meanwhile, the statistics bureau is continuing to look for new ways
    to apply hedonics. As part of its research, the agency recently
    selected 10 random items, including laundry detergent, to study as
    potential new areas to apply hedonics.

    Ron Blackwell, chief economist for the AFL-CIO, says he is concerned
    about how hedonics is used. For one thing, the method seems overly
    focused on capturing quality improvements, he says.

    "It's very careful on the adjustments of quality upwards, but not as
    careful on judging the deterioration of quality, so it's biased,"
    says Mr. Blackwell. Because of this inconsistency, he says, when the
    CPI is used to calculate Social Security payments or set wages in
    labor contracts, "it really understates the increase in prices that's
    taken place and that's experienced by workers and retirees."

    Jack Triplett, a visiting fellow at the Brookings Institution who has
    written extensively on hedonics, says he often encounters resistance
    from people who insist official inflation figures can't be capturing
    the real picture, because the government data contrast with their own
    experience. Some have suggested the CPI should be broken into
    subcategories, such as one for the elderly, which would put greater
    weight on items they buy in relatively greater amounts, such as
    health care.

    In February, Mr. LaFleur received a report about a 57-inch television
    in which the price dropped from $2,238.99 to $1,909.97. Going over
    the checklist, the data gatherer in the field discovered the old
    version had a built-in high-definition tuner. The new one did not.
    Running this through the hedonic model, Mr. LaFleur found that the
    tuner was valued at $513.69. This turned what appeared to be a 14.7%
    price decrease into a 10.7% increase.

    In hedonic calculations, the price difference is always added or
    subtracted from the previous month's figure in order to calculate the
    ultimate change.

    Similarly, in the case of the 27-inch television where the price
    appeared to stay the same, Mr. LaFleur says it was obvious to him
    that the price had declined. The latest model had a flat screen, he
    says, something which consumers value more than the curved screen in
    the old model. The newer TV also had a 10-watt stereo, compared with
    the weaker six-watt stereo in the older model.

    And to think that the people that cooked the books get jail but this rort is allowed to deceive more people and not be punished really gets my goat!
    But if they are happy play it, maybe they will give me a new 27inch tv for 329.99

  2. #2

    Default Re: The Truth about CPI

    Great article

    CPI is a crucial economic indicator. In my experience I have been seeing a lot of price increases in non-discretionary items (particulalrly food) recently. It does make you wonder when people on basic wages - controlled by CPI, survive when the price of basic goods/services rise while consumer electronics and wide screen TV's fall?


  3. #3

    Default Re: The Truth about CPI

    Ive just completed an employment drive after removing 4 thieves from my company.

    Good people are now 10%-20% dearer than last year.
    This is reflected in our pricing.

    And far less than what the thieves were getting away with.

  4. #4

    Default Re: The Truth about CPI

    The fundamental flaw with CPI in my opinion is that it is a cost of survival index rather than a cost of living index. Also the fact that it is carefully constructed to exclude things that actually go up in price.

    Most people buy houses rather than rent them. Houses are up 100%+ in price over the past 5 years. That alone blows the concept of 2-3% inflation clean out of the water.

    Personally I do not smoke but many people still do. It IS a legal product after all. Cigarettes up 300% in about 14 years according to a local shop keeper I asked.

    If I want to eat steak then I want steak. I don't want hamburger just because some statistician thinks I only want to buy the cheapest. I want the SAME quality, not the cheapest even though that bumps up the CPI quite a bit.

    Want absolute proof that the CPI is understated? Try the following. Just try and live the way someone would have done 25 years ago on todays wages and see how you go.

    1. Location is Adelaide (no reason, just wanted something other than Sydney for a change...).
    2.Typical wage of, say, 40K before tax. Don't forget there are still sub-30K full time jobs around.
    3. Man works, wife at home.
    4. Two kids of primary school age.
    5. Typical house with $250,000 mortgage.
    6. 1 car - Holden sedan base model driven 13,500km / year.
    7. Annual holidays travelling within SA. Interstate trip once every 5 years. School term breaks at home.
    8. Kids catch the bus to school.
    9. Food cooked at home. Buy mostly fresh from supermarket. Fish and chips once a week.
    10. Typical utility bills. Gas heating, cooking, hot water. No air conditioning. Rarely make STD calls and never international.

    OK, here goes. Obviously these figures are approximate. The after tax income is about $31.3K. Of this, $21828 goes into the mortgage (minimum payment over 25 years, source CBA). That leaves $9490 for everything else.

    School expenses take $1000 in total including sport, uniforms etc. That leaves $8490.

    Petrol comes to $1650 annually. Registration, insurance and servicing adds another $1500. That leaves $6340 for everything else.

    Annual holidays within SA - $1500 including accommodation, food etc with no luxuries. That leaves $4840.

    Phone, gas, electricity - $1700 leaving $3040. Put aside $1000 for replacement of car, appliances etc and the one-off interstate trip with the kids. That leaves $2040 for food, christmas presents, birthday presents, clothes, washing powder, toilet paper...

    So, can you do all your supermarket shopping and buy clothes for a family of 4 for about $40 a week? Didn't think so. Take the holidays out and it's still only $70 a week.

    What's the problem? 70% of after tax income to pay the mortgage. On historic income multiples the house would only be worth about $150,000 thus saving the family an absolute fortune on the mortgage. CPI simply hasn't counted this massive house price inflation.

    If you had house prices at a normal, average income multiple (historically 3.5 to 4 times average earnings) then that fixes everything. Likewise if wages had kept pace.

    Of course, we can't report this in the CPI since that would draw attention to the ultimate source of "inflation" in the first place. And we all know what that is... Anyone else watching the RBA's stats lately? Presses must be getting a bit hot!


    Note that the change shown is for the past WEEK, not year.

  5. #5

    Join Date
    Jan 2007

    Default Re: The Truth about CPI

    Relationship between Fed Rate and CPI & PPI.
    Fed may not cut rates as what the market had expected.

    See the link for explanation and illustration:

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