MORE OF THE DUCATI, LESS OF THE AUTHOR.

INFLATION AND FUN WITH HEDONIC PRICE REGRESSION

INFLATION AND FUN WITH HEDONIC PRICE REGRESSION[i]

SAYING “HEDONIC” IS AS MUCH FUN AS SAYING “BUTTAFUCO”

The Author’s October 16th post, “Cry Havoc and Let Slip the Dogs of Inflation”[ii], discussed the Consumer Price Index (CPI) and how it may understate inflation. Recent information the Author has read discusses this CPI weakness and offers some alternative measures.

Peter Bernstein, one of the top economic writers, discusses the distortive effect that durable goods have in the CPI. The CPI, as you may recall, is a market basket of goods and services. Housing, appliances, energy, food and the like are all components of this “basket”. Bernstein believes that durable goods have a distortive effect on the CPI[iii] He cites two reasons for this distortive effects. And both of these effects offer a good review of some basic economic principles:

A. Quality Improvement and Hedonic Price Regression. Technological improvements in products increases product quality and can also lower the price of a product. Let’s use the examples of calculators, cars and clothes dryers[iv].

Calculators. Electronic calculators have been around since the early-to mid-1970s. The first models approached $100 dollars. But with in just a few years, technological improvements lowered the price to just a few dollars. Today, you can probably get one for $.99. The quality of calculators has improved and many inexpensive models have more functions. But most folks use calculators for basic arithmetic and the cost of doing that basic arithmetic has plummeted since the introduction of the electronic calculator.

Automobiles. Automobile quality has increased dramatically over time. American cars from the 1960s and 1970s were usually worn out well before 100,000 miles. They required frequent oil changes and tune-ups. Tires had to be changed more frequently.

Compare that to the quality of today. Vehicles can last for more than 200,000 miles. They require far less maintenance due to fuel injection, electronic ignition and improvements in internal engine components. Automobiles have increased in price over time, but the vehicles today are better machines with far more features and comfort measures.

Clothes Dryers. This is a real example culled from the CPI and the Bureau of Labor Statistics. [v] One of the components of the CPI market basket is appliances. In the year 2000, the Bureau of Labor Statistics made an Hedonic Price Regression adjustment on the price of clothes dryers. Basically, they considered the fact that clothes dryers of the year 2000 contained many consumer features that were not present in dryers from 20-30 years ago. The Bureau then adjusted the price weighting of the dryer because it had more features that consumers could use. So if the price of dryers had remained the same over the past few years but more features have been added, a hedonic pricing regression could be made to reflect that fact that the new features has actually “reduced” the price of the dryer

Bernstein’s issue with hedonic price regression is that even though the product may have more features that the consumer could use, the consumer may not WANT, these features. The consumers may still want only a basic product. So in the mind of the consumer, the price of the good has still gone up, despite its augmented features. For this reason, Bernstein believes that durable goods should be dropped from the CPI. Section B, below addresses another reason for the deletion of durable goods from the CPI.

B. Consumers Buy Nondurables and Services Every Day. Durables are infrequently purchased, states Bernstein. Food, energy, clothing and housing are purchased on a daily basis. These are the items where inflation bites consumers and erodes purchasing power. And there is another economic phenomena going on. This is the Substitution effect. An example the Author learned in economic classes in the 1970s is instructive and also reflects those times. If the price of butter goes up, people substitute butter with margarine. Today, many people (like the Author) substitute margarine for butter because of the high fact content of butter. But nonetheless, the Substitution effect is still operable.

Substitutive effects are also possible with consumer durables. People can ride the bus or commuter train instead of buying a car. Or they can buy a scooter or peddle a bike. The laundry mat is a substitute for a washer and dryer.

Bernstein offers in place of the CPI an inflation index called the CPI/DX. This index includes all consumer nondurable items and services from the CPI, but not the durables. Since 1999 the CPI/DX has risen at an annual rate of 3.1%, while the CPI has risen by 2.5% and Core CPI by 2.1% (Core Inflation does not include the volatile food and energy components).

It is doubtful that any index will soon supplant the venerable CPI. The CPI is ingrained in our finance system and is the standard for inflation measurement. Labor contracts, government regulations, contracts and other financial relationships use the CPI to adjust prices and costs. But it is worthwhile to note the potential inaccuracies of the CPI and recognize there are other metrics that may be more accurate or appropriate in certain scenarios.

WE ARE ALWAYS KEEPING SCORE IN THE DESERT OF THE REAL!

[i] The Author, despite having a graduate and post-gradute education, still retains his inner “Beavis and Butthead”. He snickers when he reads or writes the phrase “Hedonic Pricing” It just sounds R-rated. “Uh, huh. huh, he said Hedonic”.
[ii] This quote is a paraphrase of a line from William Shakespeare’s Julius Caesar. The footnote that attributed the title of the earlier post fell out of the text in the final edit. The Author apologizes for this oversight. Be assured that despite the poor quality of writing and analysis in this Newsletter, the Author strives to obey the basic norms of journalistic standards.
[iii] Bernstein, quoted in John Mauldin’s newsletter, “Inflation and Fed Policy”, www.frontlinethoughts.com, October 21, 2005.
[iv] http://www.bls.gov/cpi/cpidryer.htm,
[v] See BLS article in endnote iv.