The Hocus-Pocus of CPI: How economists transform a 400% price increase into a 7% decline

[Occam's Banana]

h/t Joe Salerno @ Mises.org (The Hocus-Pocus of CPI Calculation)
http://mises.org/blog/hocus-pocus-cpi-calculation

h/t Tyler Durden @ Zero Hedge (The Magic Of CPI: Watch How Economists Transform A 400% Price Increase Into A 7.1% Decline)
http://www.zerohedge.com/news/2014-1...ase-71-decline

[all emphasis in original - OB]

Manipulating the Consumer Price Index: Hedonic Quality Adjustments
http://priceillusion.wordpress.com/2...y-adjustments/
Consumer Price Illusion (04 November 2014)

Have you heard the one about CPI?

Suppose that a TV manufacturer retires a product and replaces it with a newer, better, and much more expensive one. If the new TV costs 5 times more than the old one, how can we gently massage the price of the old TV to make it look like the price fell? By using the dark arts of econometrics, my son!

If you believe the public comments made by the world’s central bankers, the prices that consumers pay for items are not rising fast enough; in some places like Europe they worry that prices might actually fall (a tragedy for the possessing classes, as their manic one-way long bets might not work then). Central bankers are terrified of this outcome. Setting aside for a second the apparent insanity of this logic for your average consumer, who experiences price rises on a near continuous basis, let’s examine in detail one of the gauges economists use for measuring prices: the Consumer Price Index (CPI).

Ostensibly, the CPI is a linear combination of the “prices” of things/stuff consumers could actually purchase weighted by a percentage that the “ideal consumer” spends on any particular stuff/thing in his “ideal” basket. The main problem here is that the “prices” used are not the prices a consumer would actually pay; instead the real price for an item is scaled by what the BLS calls a “Hedonic Quality Adjustment (HQA)”. The HQA was designed to solve a real world problem economists face: the market keeps pumping out new and better devices. In practice the HQA is used to artificially depress the prices used in the calculation of the CPI.

Intuitively, the HQA scales prices by their “perceived” quality. We’re not talking about human perception here, but that of a kitchen sink regression model created by BLS economists. Essentially it throws every quality an item might possess into a linear model and performs a regression of these qualities against the prices found in the market for a given product. The prices that feed into the CPI can be intuitively modeled as:



This means that as far as the CPI is concerned, prices can “decrease” for three reasons:

• The price actually decreases, holding quality constant
• The “quality” as measured by the Hedonic Quality Regression (HQR) could go up, holding price constant
• The “quality” goes up by more than prices go up (<<<<<< WE’RE HERE RIGHT NOW)

In a time of rapid technological development, the quality as measured by HQR will increase by orders of magnitude more than prices. Consider Moore’s Law, which correctly postulated that the number of transistors on computer chips would double every two years; prices can’t possibly keep up with that kind of quality increase (save for hyperinflation, more on that later).

The BLS neatly illustrates this effect with an example from their website (emphasis is mine):

Item A is a television that is no longer available and it has been replaced by a new television, Item B. The characteristics in bold differ between the two TVs. There is a large degree of quality change and there is a very large (400%) difference in the prices of these TVs. Rather than use the 400 percent increase in price between Item A and Item B, the quality adjusted rate of price change is measured by the ratio of the price of Item B in the current period ($1,250.00) over an estimated price of Item B in the previous period – Item B’.

Here is an example of a hedonic regression model [including coefficients] for televisions.

This is just an OLS linear regression model. The dependent variable is the natural log of prices for televisions, the explanatory variables and their coefficients are listed in the table below (most are dummy variables).

To derive the estimated price of Item B’, we use the following equation:



Where PB,t+s-1 is the quality adjusted price, PA,t+s-1 is the price of Item A in the previous period, and is the constant e [SIC], the inverse of the natural logarithm, exponentiated by the difference of the summations of the ßs for the set of characteristics that differ between items A and B. The exponentiation step is done to transform the coefficients from the semi log form to a linear form before adjusting the price.

To put it another way, the HQR extrapolates a price for the new TV using the Hedonic Quality model estimated from the population of old TV’s.

For our television example, [the equation above] looks like this:



When this quality adjustment is applied, the ratio of price change looks like this:



The resulting price change is -7.1 percent after the quality adjustment is applied.

Oh good! You see, my neighbor, John Q., thought that prices were going up and was about to riot in the streets because he couldn’t buy anything now. How relieved he was to live next to an economist and mathematician; I merely explained that even though he couldn’t afford the new TV (or anything else) it was actually less expensive once quality was taken into account. Boy was his face red. He went home and explained it to his wife and kids and they laughed and laughed about their mistake.

Few modern people would consider progress to be a bad thing. Quality improvements should be celebrated and technological change embraced. Yet when a policymaker says that she wants inflation to pick up and trots out the CPI as evidence, she doesn’t care whether that comes about from actual price inflation or quality decreases. Given the accelerating pace of technological improvements, it’s hard to imagine an outcome besides hyperinflation that will satisfy central bankers and their slavish dependence on indicators which have been so far abstracted from reality as to have little actionable value.

Alternatively, causing a complete economic meltdown by manipulating the price of money and inflating the mother of all bubbles will probably slow down technological development, so either way, well played.

Since economists are largely concerned with “real” prices (actual prices scaled by inflation as measured by the CPI), any error in the calculation of real prices introduces a bias that propagates to every corner of economic thought. This is a central flaw in economics that largely explains the gap between actual human experiences (“Wow! Things are expensive!”) with central bankers gambling our collective future on fighting deflation.

More than likely the deflation is used as cover for the agency problem faced by central bankers every day. Most market practitioners know we are in a classic debt-fueled bubble initiated by wildly loose monetary policy – central bankers included. Given that the public will rightfully blame policymakers when the bubble bursts, no central banker wants to run the risk that it pops on their watch. That would make them look stupid, and might endanger their future lives as highly paid consultants. In that context printing endless supplies of money makes perfect sense.

[tod evans]

Before I even read the article I knew I had to drop this here;

[Ronin Truth]

Smoke & mirrors & spin & BS!

[Madison320]

They shouldn't be using things that change drastically like electronics. They should only use basic things that are stable like milk, eggs, gold, oil, etc. Comparing the price of a television from 10 years ago to one today is like comparing the price of an apple 10 years ago to an orange today.

[Zippyjuan]

How has the price inflation been on plasma TVs? When they first came out, they cost $10,000 or even $20,000 for a 50 inch screen. Today you can get one for about $400. That is a 98% price decrease.

Article from 2005: http://www.nytimes.com/2005/08/20/te...ices.html?_r=0

All this spells good news for anyone thinking about upgrading from the old cathode-ray TV to screens that are 40 inches or larger in the three most popular formats. Full-featured plasma TV's with 50-inch screens that sold for $20,000 five years ago could edge close to $4,000 this season. A liquid-crystal-display version and a rear-projection TV with a digital light-processing chip will be considerably less, closing in on $1,800.

Ad today: http://www.abt.com/product/67821/Sam...aign=PN51F4500

$397.99.

How does that impact the CPI?

[Zippyjuan]

They shouldn't be using things that change drastically like electronics. They should only use basic things that are stable like milk, eggs, gold, oil, etc. Comparing the price of a television from 10 years ago to one today is like comparing the price of an apple 10 years ago to an orange today.

Which is why the CPI updates what they include in their "basket" and the weightings things have. They try to look at what people actually buy vs what they used to buy. Food changes too. There are hundreds if not thousands of new food items available. People used to prepare more of their own food so they bought more basics- flour, butter, eggs, milk. Today they buy more prepared things. There are items unavailable even ten years ago like greek style yogurt or quinoa taking larger parts of the market. Food now occupies a smaller part of the typical household budget as well. It used to be 30% of expenses. Now it is about eleven percent. If we only looked at foods people bought 50 years ago and gave them the same weights they did back then, the inflation figure would be highly distorted from what consumers actually experience today.

[Madison320]

Which is why the CPI updates what they include in their "basket" and the weightings things have. They try to look at what people actually buy vs what they used to buy. Food changes too. There are hundreds if not thousands of new food items available. People used to prepare more of their own food so they bought more basics- flour, butter, eggs, milk. Today they buy more prepared things. There are items unavailable even ten years ago like greek style yogurt or quinoa taking larger parts of the market. Food now occupies a smaller part of the typical household budget as well. It used to be 30% of expenses. Now it is about eleven percent. If we only looked at foods people bought 50 years ago and gave them the same weights they did back then, the inflation figure would be highly distorted from what consumers actually experience today.

Yup, that's why the CPI is bogus. Comparing apples to oranges and making all sorts of subjective decisions.

[Occam's Banana]

How has the price inflation been on plasma TVs? When they first came out, they cost $10,000 or even $20,000 for a 50 inch screen. Today you can get one for about $400. That is a 98% price decrease.

Article from 2005: http://www.nytimes.com/2005/08/20/te...ices.html?_r=0

Ad today: http://www.abt.com/product/67821/Sam...aign=PN51F4500

$397.99.

How does that impact the CPI?

Did you even read the OP article?

The government's hedonics-adjusted CPI calculations (with respect to TVs) are NOT based on comparing the price of plasma TVs today with the (actual) price of (actual) plasma TVs yesterday (let alone "when they first came out").

[N.B.: In the above and the following, the word "today" denotes the point at which a given CPI calculation was made, and the word "yesterday" denotes whatever interval of time was used to source prices previous to "today."]

The representative "ideal consumer" referenced in the article - in relation to whom the government calculates its CPI figures - is not a "first adopter" buying the latest, greatest & most expensive cutting-edge gadgets. He is just a "typical" consumer buying a TV that is "typical" for the day. (And even more recently than when plasma TVs "first came out," CRT TVs were "typical" and plasma TVs were not - while now, plasma TVs are "typical" and CRT TVs are not.)

But price inflation with respect to TVs is not even measured by comparing the price of a "typical" TV today with the actual price of a "typical" (and actual) TV yesterday - at least, not under the government's way of doing CPI calculations. Instead, the government uses "Hedonic Quality Adjustments" (HQAs) in order to compare the price of a TV today with the fictional price of a fictional TV yesterday.

The "hedonic" regression adjustment (HQA) is based on completely ignoring the actual price of actual TVs yesterday and instead "back-extrapolating" what a TV with today's qualities supposedly would have cost if it had been available yesterday (despite the fact that it did not even exist then). And since a TV with today's qualities (had it even existed) is ceteris paribus bound to have been more expensive yesterday than it was today, using "hedonic" adjustments is virtually guaranteed to turn even significant price increases into price declines - such as turning a 400% price increase into a 7% price decline (as presented in the example in the OP article).

As detailed in the OP article, the government's CPI calculations start out with something like THIS ...



... and then HQA regression is applied to magically transform the above into THIS ...



... and then THAT is used to claim that the price of TVs has gone down 7% - while the "ideal consumer" (a.k.a. John Q. Public) is actually paying 400% more today than he was yesterday for a new TV.

In other words: When "ideal consumers" (upon whom the government's CPI calculations are made) go from buying $250 CRT TVs to buying $1250.00 plasma TVs, then the government will claim that the price of TVs has gone down by 7% (and NOT up by 400%) ...

In other other words: The government's CPI figures (and how they are calculated) are complete and utter BULL$#@! ...

(And if you don't like the example that has been presented - because you think it's contrived or rigged or inaccurate or whatever - then you should go complain to the government about it. It's their example. As noted in the OP article, all of this comes right from the horse's mouth. Everything in the quote boxes in the OP is taken directly from the "Frequently Asked Questions about Hedonic Quality Adjustment in the CPI" page at the Bureau of Labor Statistics website - which you can find here: http://www.bls.gov/cpi/cpihqaqanda.htm).

[Occam's Banana]

Yup, that's why the CPI is bogus. Comapring apples to oranges and making all sorts of subjective decisions.

It's even worse than that. It's more like subjectively comparing apples to non-existent oranges ...

[Occam's Banana]

Bump for another thread: http://www.ronpaulforums.com/showthr...-Of-Pink-Slime

[timosman]

How has the price inflation been on plasma TVs? When they first came out, they cost $10,000 or even $20,000 for a 50 inch screen. Today you can get one for about $400. That is a 98% price decrease.

Only if you never leave your house.

[TheCount]

In other words: When "ideal consumers" (upon whom the government's CPI calculations are made) go from buying $250 CRT TVs to buying $1250.00 plasma TVs, then the government will claim that the price of TVs has gone down by 7% (and NOT up by 400%) ...

In the month of January you don't have a job and you're eating cube steak with your savings.

In April you get a job and you start buying ribeye.

How much has the price of meat changed?

[Occam's Banana]

In the month of January you don't have a job and you're eating cube steak with your savings.

In April you get a job and you start buying ribeye.

How much has the price of meat changed?

I don't know. You haven't specified any prices.

[angelatc]

I merely explained that even though he couldn’t afford the new TV (or anything else) it was actually less expensive once quality was taken into account.

TVs are a bad example because you can pick up a working TV for free these days.

Cars are a better example.

[Suzanimal]

In the month of January you don't have a job and you're eating cube steak with your savings.

In April you get a job and you start buying ribeye.

How much has the price of meat changed?

I don't know. You haven't specified any prices.

Cube steak isn't cheap. If you're unemployed, beans or chicken are a cheaper source of protein.

The cheapest price for cube steak is right around 4.00 per pound and rib-eye is right around 10.00 per pound. If you buy them at the same store, you're going to pay 4.00 per pound for cube steak and 14.00 per pound for rib-eye. The cheapest place to buy rib-eye doesn't sell cube steak. I keep a price notebook. Those prices are for decent cuts of meat but not high quality grass fed. You'll pay more for that.

At the Asian grocery store, you can buy top round for 4.50 per pound and "cube" it yourself or you can buy rib-eye for 5.99 per pound. I wouldn't buy it there, though. Their meat department smells disgusting. Plus, it kind of turns me off to buy meat with a bunch of goat heads looking at me. o_O

[acptulsa]

TVs are a bad example because you can pick up a working TV for free these days.

Cars are a better example.

Cars aren't a good example, either, because ever-increasing government regulation drives those prices up nearly every year for no good reason. Motorcycles might work. But as Zippy will be along to explain as soon as he clocks in, they refuse to use motorcycles because those are a luxury item. They aren't an absolute necessity like your propaganda devic--er, I mean television.

[Madison320]

In the month of January you don't have a job and you're eating cube steak with your savings.

In April you get a job and you start buying ribeye.

How much has the price of meat changed?

Which is farther, to Los Angeles or by bus?

[TheCount]

I don't know. You haven't specified any prices.

The prices don't matter because they haven't changed.

Cube steak isn't cheap. If you're unemployed, beans or chicken are a cheaper source of protein.

It's cheaper than ribeye and if I'd used beans or chicken as the comparison then people would complain that it wasn't equivalent to the TV example.

Based on your prices ($4 and $10) then that's 250% inflation in the price of meat, all of which would be measured in the month of April.

Which is farther, to Los Angeles or by bus?

Exactly. I agree.

[devil21]

All I know is that I used to get a huge kick-ass dinner (even had to doggie-bag the excess) for two at Cheesecake Factory for around $60 twenty years ago. Today, seems like every meal for two pegs about $50 for really basic items at even the most average restaurant.

[loveshiscountry]

What about healthcare insurance being weighted at ~ 1 percent? Isn't that enough to debunk it?

[Occam's Banana]

The prices don't matter because they haven't changed.

again.

Then what does it have to do with inflation (let alone "hedonics" adjustments to CPI numbers)?

That people choose to buy more or less expensive items as their personal incomes increase or decrease has nothing to do with how inflation is calculated.

It's cheaper than ribeye and if I'd used beans or chicken as the comparison then people would complain that it wasn't equivalent to the TV example.

Based on your prices ($4 and $10) then that's 250% inflation in the price of meat, all of which would be measured in the month of April.

The essential fatuity of expressing inflation in the manner you have done here is the whole point of the OP article. The only difference is that you have not deepened the fatuity by attempting to engineer a fictional historical price for fictional meat by applying "hedonics" regression (as the BLS does with respect to televisions, by its own example).

It makes no sense to try to measure price inflation by taking the price of one particular kind of meat (cube steak) at one time (January) and comparing it to the price of some other, entirely different kind of meat (ribeye) at some other time (April) while the first kind of meat (cube steak) is still readily available at the later point (April). IOW: Your cube-steak-vs.-ribeye scenario is not a valid analogy to the comparison of the erstwhile price of CRT televisions to the present price of plasma TVs*. The purchase of CRT televisions is no longer predominantly "typical" (as it once was) for "ideal consumers," and you would have to go out of your way to find such TVs today (assuming they even still make them for the retail market). That is not the case for cube steaks.

Thus, you must do one of the following:
(1) compare the price of cube steak in January vs. the price of cube steak in April, or
(2) compare the price of ribeye in January vs. the price of ribeye in April, or
(3) compare the average of the prices of a "basket" of meats (beef, pork, chicken, fish, etc.) purchased by "ideal consumers" in January vs. the average of the prices for the same things in April.

And at any rate, as far as I know "hedonics" adjustments are not applied to meat cuts, so none of this has anything at all to do with the bogus use of "hedonics" as a fudge factor in order to conceal inflation by trying to make it appear as though the prices of certain "typical" consumer goods (such as TVs) purchased by "ideal consumers" have gone slightly down instead of significantly up.



* And note that the problem is not that the BLS compares erstwhile CRT prices to present plasma prices. That is (or can be) a sensible thing to do, as each was or is a "typical" TV for its time. The problem is that the BLS compares present "typical" (plasma) prices not to previous "typical" (CRT) prices, but rather to the entirely fictional and "back extrapolated" prices that they claim present plasma TVs would have had when CRTs were prevalent (but did not actually have, because present plasms TVs did not even exist then). Since the prices of present plasma TVs would ceteris paribus likely have been much higher had such devices been available then, this all but guarantees an apparent decrease in pirces. IOW: It's not that they are comparing apples to oranges, it is that they are comparing apples to non-existent apples that have been conjured up from out of nowhere ...