Thursday, May 13, 2021

Consumer Price Index: "I’m Trying To Understand Hedonic Adjustments"

 Commended to our attention by Jemima Kelly via FT Alphaville's Further Reading post.

From Epsilon Theory, May 10 (i.e. pre-CPI reporr):

Brent Donnelly is a senior risk-taker and FX market maker at HSBC New York and has been trading foreign exchange since 1995. He is the author of The Art of Currency Trading (Wiley, 2019) and his latest book, Alpha Trader, hits the shelves in Q2 2021.

You can contact Brent at and on Twitter at @donnelly_brent.

As with all of our guest contributors, Brent’s post may not represent the views of Epsilon Theory or Second Foundation Partners, and should not be construed as advice to purchase or sell any security.

With the intense sturm und drang around inflation right now, expect the next six months to yield intense hand-wringing and chin scratching over CPI, PCE and … hedonic quality adjustment. Quite often when people go to Twitter to rail about CPI, they say something like “Man, my cost of living doesn’t look like that! My tuition and health care costs are skyrocketing!” Savvy statisticians then respond with a flurry of charts that look like the one at right and say “the plural of anecdote is not data” or something similar.

So all those rising prices are being offset by all those falling prices and people are just noticing the prices that go up, right? Nope. The source of the data on that chart is the BLS, the U.S. organization charged with preparing the CPI data. The data has been sliced and diced like crazy.

The CPI index is not a cost of living measure! It is a hedonically-adjusted basket of assumptions that attempts to track some sort of cost vs. quality / total-utility metric over time. So what exactly is hedonic quality adjustment? Let’s ask the BLS:

Hedonic quality adjustment is one of the techniques the CPI uses to account for changing product quality within some CPI item samples. Hedonic quality adjustment refers to a method of adjusting prices whenever the characteristics of the products included in the CPI change due to innovation or the introduction of completely new products.

The use of the word “hedonic” to describe this technique stems from the word’s Greek origin meaning “of or related to pleasure.” Economists approximate pleasure to the idea of utility – a measure of relative satisfaction from consumption of goods. In price index methodology, hedonic quality adjustment has come to mean the practice of decomposing an item into its constituent characteristics, obtaining estimates of the value of the utility derived from each characteristic, and using those value estimates to adjust prices when the quality of a good changes.

The CPI obtains the value estimates used to adjust prices through the statistical technique known as regression analysis. Hedonic regression models are estimated to determine the value of the utility derived from each of the characteristics that jointly constitute an item.

There is a significant degree of modelling and massaging going on. The BLS dances around the CPI as cost of living measure question here (see question #9) and the media often inaccurately describe CPI data as changes in cost of living. This leads to a situation where people see prices ripping higher and CPI at 2.0% and it makes them want to yell at CPI.

Since I always think of TVs and cars as goods that have seen flat or falling prices over the years, I decided to have a quick peek at the real life vs. BLS-imagined price movements in the world of new vehicles. I made the arbitrary and grossly simplifying decision to use the Honda Accord and the Ford Mustang as my cars because they have been popular for more than 30 years, there is plenty of historical pricing data, and their target demographics and brand image haven’t changed much over time....