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Published on Gold Anti-Trust Action Committee (http://www.gata.org)

The perfect storm that could drown the economy

By cpowell
Created 2005-05-09 07:00

New and Improved

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

By Timothy Aeppel
The Wall Street Journal
Monday, May 9, 2005

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
changed.

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
percent.

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
decision."

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.

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