Substitutions and Hedonics: Inflation Data Absurdities

by: Barry Ritholtz

I have long railed against many of the absurdities associated with modern Inflation reporting. Let's take a closer look at some of the specifics:

Start with the inherent bias built into the BLS models, and their tendency to understate inflation. Next, add a sprinkle of substitutions, quality improvements, and hedonic adjustments, all of which rationalize price increases as somehow non-inflationary.

Then, we have the Fed's focus on core inflation, which tends to ignore the non core items like Food and Energy (besides, who really needs Food and Energy anyway?). A variation on Core Inflation is Wall Street's love affair with Inflation -ex-inflation, which is a basket of only those goods and services that have not gone up in price.

Finally, the latest inflation innovation is a new concept I call Uni-directional Inflation, which states that when certain items (e.g., Oil, Corn, Copper) go up in price, it is not inflationary - but when those same items drop in price, it's proof positive that inflation has been vanquished.

We discussed a few of the differences last week between U.S. and UK inflation data in "The Sordid Truth About Inflation." By the time the UK inflation arrives here, it's so tired by its swim across the pond that it can't move the BLS needle at all.

Let's take a closer look at two of my favorite inflation data absurdities, Substitutions and Hedonics:

Substitutions: There have been numerous academic approaches to this subject. See for example An Expert System for Reviewing Commodity Substitutions in the Consumer Price Index [BLS], or the Testimony of Fed Governor Edward Gramlich on Improving the consumer price index. They are mostly exercises in futility.

It's one thing to try to understand consumer behavior in the context of the real world: In the real world of finite budgets and price sensitive consumers, substitution is an actual consumer behavior. However, it's another thing entirely to pervert this behavior and offer it as proof of less inflation. It's nonsense.

When someone buys chicken instead of steak because meat has gone up in price, that's evidence of inflation. The substitution process fraudulently rationalizes this to eliminate inflation from the BLS basket. Indeed, substitution is PROOF of inflation. When a product's price rises out of a consumer's ability to afford purchasing it, it's prima facie evidence of inflation. Only the starry eyed residents of ivory towers can say with a straight face that cheaper substitutes are non-inflationary.

When consumers engage in substitution, they are explicitly acknowledging inflation. Incidentally, the intellectually dishonest sleight of hand of substitution is courtesy of the Boskin Commission.

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Hedonic Adjustments: Hedonics asks the question: "How much of a product's price increase is a function of "inflation," and how much is quality improvement?" Thus, the entire late 1990's concept of Hedonics is premised upon a flawed assumption: that quality is static.

In reality, all products incrementally improve over time. Indeed, it is the very nature of all technology - from fire to the wheel to the iPod - that they become better/faster/cheaper/feature-laden over time.

Rather than claim this as non-inflationary proof, I say instead it is evidence of mankind's genius. Other than a few centuries when religious zealots prevented it, our entire history is one technological progress. We make things, then we make them better, then someone else improves upon them, on and on and on. It is the natural order of things. The theory of Quality Adjustments is flawed at best. To claim inflation is overstated due to improvements reveals a misunderstanding of the essence of human inventiveness, as change and quality improvements are part of our very nature.

Hedonics are the bastard stepchild of flawed assumptions and abstract theory. To call it dishonest serves only to slander liars. Consider:

Hedonics opens the door to producing magical results: a lower inflation rate with generally rising prices, a higher growth rate although the economy may be weaker, and a higher productivity number, although productivity would have been declining without the hedonic imputations.

--The Illusions of Hedonics

Nice trick.

We should not confuse inflation with industrial economics of scale. Early versions of products cost more because the first units are manufactured in small batches, with much of the R&D costs included. As any product moves from the early adopters towards the mainstream, prices decrease, quality and functionality improves, commoditization occurs. This is to be expected.

For example, take ABS brakes in the past, or Dynamic Stability (or Traction) Control in the near future. When these first were introduced, they were expensive options. As time progressed, the chips that make these possible dropped in price. Now, they cost so little that it's standard on every car (DSC is mandated to be on every car in the future). Same with Airbags. Indeed, soon you will not be able to buy a car without both of these (and nearly every new vehicle today comes with Airbags and ABS). You won't be able to "substitute" the cheaper version if you wanted to.

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Hedonics is a variation of the old trick of comparing the present with the past, instead of the present. Measuring quality improvements is a distraction from the real measure of inflation: the purchasing power of a dollar.

Does your money still buy you an equivalent vehicle (i.e, middle of the product line) for an equivalent amount?