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On Saturday, the Wall Street Journal had an article called Food Makers Scrimp on Ingredients In an Effort to Fatten Their Profits. Good article, but I’m here to draw a different conclusion than the article did.  How much impact does substituting cheaper ingredients in prepared food have on the CPI if the product price does not change?  No effect, but you are likely getting a lower quality good.

I don’t have troubles with the theory behind hedonic adjustment.  I have troubles with how it works in practice, and I wonder whether it can be done properly at all, as I wrote in my RM article Solid Foundation for Inflation Fears.

One requirement for doing hedonic adjustment right  is that both the new and old goods must be offered side-by-side for a while, and that people can clearly tell the differences between the old and new goods.  At that point, the economist can take the prices paid and quantities bought of both goods, and make a hedonic adjustment.

But typically, that doesn’t happen.  The old product disappears when the new product appears, and when features are upgraded, companies loudly announce the enhancements (and in a soft voice, the higher price).  When features / ingredients are downgraded, the companies say little to nothing.

But mere technical measurement of quality changes does not capture the perceived quality difference to the consumer.  Consider a soft drink company that changes its bottle size from 16 to 20 ounces (25% bigger), while raising the price 33%.  The consumers may say in their heads, “I only buy one bottle per day, and I don’t need the extra four ounces, but I have to buy one bottle of my favorite soda; I can’t buy 80% of a bottle, and this is it.”  The consumers aren’t 6.7% worse off in this example; the inflationary effect should be higher.

Same thing for computers.  Any comparison of features will overstate the perceived improvement, because for most needs of companies and individuals, computers run about the same — marginally improved hardware, and software that eats up a lot of resources, leading to little extra benefit.

With a little sympathy toward those who calculate the CPI, I will say that I think their job is tough.  Capitalist economies are diverse and dynamic.  They sample a smallish portion of what goes on, often on a static basket of goods that is infrequently updated, and try to generalize to the large, diverse, dynamic economy that we live in.  It is tough, and I know they have to do it for a wide number of reasons.  They use shortcuts.  They have to, in order to get their jobs done.  But those shortcuts bias the calculation of the CPI downward.

My advice would be this: Aside from products where quality differences can be plainly figured (both goods trading side-by-side, with differences clearly identified), drop the hedonic adjustments.  This is one of the reasons why US inflation is so much lower than much of the rest of the world, and the government should be more honest about the value of our currency.

In closing, as an aside, can you imagine a question given at the Presidential debates that went something like this: “Senator, the leading bond manager of our country, and many leading financial writers (e.g. James Grant, Barry Ritholtz) have argued that the way that the government calculates the CPI is flawed, and understates the change in the cost of living.  If elected President, what would you do about this?  Further, how would it affect who you appoint to the FOMC?”

That one would probably even make Obama pause.  McCain? I like the guy, but I don’t know what he would say.  What it would point out is how little scrutiny is really given to a core statistic that affects our lives in many ways, because it affect indexed payments, and helps define how fast the economy is really growing.  If I am correct in my assertion in the degree of understatement of the CPI, then we have been in recession for some time already.

And, for me, though I am doing well, all my friends are less well off than me.  From what I can gauge, I don’t see many whose standard of living is rising now.  So it goes.